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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 2000
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 000-26873
DIGEX, INCORPORATED
(Exact name of registrant as specified in its charter)
DELAWARE 59-3582217
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
ONE DIGEX PLAZA
BELTSVILLE, MD 20705
(Address of principal executive offices)
(240) 264-2000
Telephone Number
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, PAR VALUE $.01 PER SHARE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment in this Form 10-K. [ ]
Aggregate market value of the voting stock held by non-affiliates(1) of the
registrant on February 28, 2001: $444,735,381.
As of February 28, 2001, there were 24,622,028 and 39,350,000 shares of the
Registrant's Class A and Class B Common Stock outstanding, respectively.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of the Form 10-K will be incorporated by reference from the
Registrant's Proxy Statement for the 2001 Annual Meeting of Stockholders.
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(1) As used herein, "voting stock held by non-affiliates" means shares of Common
Stock held by persons other than executive officers, directors and persons
holding in excess of 5% of the registrant's Common Stock. The determination
of market value of the Common Stock is based on the last reported sale price
as reported by the Nasdaq Stock Market on the date indicated. The
determination of the "affiliate" status for purposes of this report on Form
10-K shall not be deemed a determination as to whether an individual is an
"affiliate" of the registrant for any other purposes.
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DIGEX, INCORPORATED
INDEX
PAGE
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PART I
Item 1 Business.................................................... 1
Item 2 Properties.................................................. 23
Item 3 Legal Proceedings........................................... 24
Item 4 Submission of Matters to a Vote of Security Holders......... 25
PART II
Item 5 Market for Registrant's Common Equity and Related
Stockholder Matters......................................... 26
Item 6 Selected Financial and Other Operating Data................. 27
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 30
Item 7A Quantitative and Qualitative Disclosures About Market
Risk........................................................ 40
Item 8 Financial Statements and Supplementary Data................. 40
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 40
PART III
Item 10 Directors and Executive Officers of the Registrant.......... 41
Item 11 Executive Compensation...................................... 41
Item 12 Security Ownership of Certain Beneficial Owners and
Management.................................................. 41
Item 13 Certain Relationships and Related Transactions.............. 41
PART IV
Item 14 Exhibits, Financial Statement Schedules and Reports on Form
8-K......................................................... 42
Signatures.................................................. 47
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PART I
References in this report to "we," "the Company," or "Digex," mean Digex,
Incorporated except where the context otherwise requires. This report contains
certain "forward-looking statements" concerning Digex's operations, economic
performance and financial condition, which are subject to inherent uncertainties
and risks. Actual results could differ materially from those anticipated in this
report. When used in this report, the words "estimate," "plan," "project,"
"anticipate," "expect," "intend," "believe" and similar expressions are intended
to identify forward-looking statements.
ITEM 1. BUSINESS
OVERVIEW
We are a leading provider of managed Web hosting services to businesses
operating mission-critical, multi-functional Web sites. We also offer related
value-added services, such as firewall management, stress testing and consulting
services, including capacity and migration planning and database optimization.
From major corporations to Internet start-ups, our customers use our services to
rapidly and cost-effectively deploy secure and reliable business solutions
including on-line banking, on-line procurement and electronic retailing. Our
services include providing the computer hardware, software, network technology,
and systems management necessary to offer our customers comprehensive outsourced
Web site and application hosting solutions.
We believe our singular focus on delivering mission-critical Web site and
application hosting solutions has been the major contributor to our growth. We
currently serve over 600 customers, including 37 of the Fortune 500 companies.
We operate three state-of-the-art data center campuses strategically positioned
on the east and west coasts of the United States and in the United Kingdom. We
own and manage approximately 4,216 Window- and UNIX-based servers in these data
centers. Our revenues grew at a compounded annual growth rate of 178% between
1996 and 2000, from $2.8 million in 1996 to $168.1 million in 2000.
The following are among the key factors that we believe will continue to
drive our growth:
- the ability to facilitate the rapid, cost-efficient implementation and
expansion of customers' Web site initiatives;
- an operating platform designed to allow us to scale our operations to
achieve higher revenues, lower marginal unit costs and increased
operating margins;
- strong alliances with Microsoft Corporation and Compaq Computer
Corporation, each of whom have equity investments in Digex;
- strong working relationships with other technology leaders including
Sun Microsystems and Cisco Systems;
- an experienced management team and technical experts, who in the
aggregate hold over 900 technical certifications from leading
companies such as Cisco Systems, Microsoft and Sun Microsystems;
- a highly skilled engineering organization dedicated to identifying the
best available tools, technologies and processes;
- a growing, geographically distributed sales force; and
- a network of over 100 business alliances which provide complementary
design, development and integration services for our customers and
which represent a significant source of new customer referrals for
Digex.
We believe we have established a reputation for reliable service, prompt
deployment and quality customer service. To meet our customers' evolving
requirements we continuously seek to identify, test and utilize the best
available technologies and processes. Scalability is a central element of our
operating strategy. Our architecture was specifically designed to facilitate the
rapid, cost-efficient implementation and expansion of our customers' Web hosting
initiatives.
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OUR HISTORY
Our business started in 1996 as the Web site hosting unit of Business
Internet, Inc., previously known as DIGEX, Incorporated, a company that was
principally an Internet access and Web site hosting services provider. Business
Internet went public in October 1996 under the name DIGEX, Incorporated, and was
acquired by Intermedia Communications Inc. in July 1997. In contemplation of our
initial public offering, we were incorporated as Digex, Incorporated in April
1999, and Business Internet contributed our assets to the newly formed Digex,
Incorporated in order to effect a recapitalization of our business. On August 4,
1999, we sold 11,500,000 shares of Class A Common Stock in our initial public
offering. Subsequent to our initial public offering, Business Internet
contributed our Class B Common Stock to its wholly-owned subsidiary, Intermedia
Financial Company.
RECENT DEVELOPMENTS
Intermedia -- WorldCom Merger
On September 1, 2000, Intermedia entered into a merger agreement with
WorldCom, Inc. Upon consummation of the merger, a subsidiary of WorldCom will be
merged with and into Intermedia and Intermedia will become a subsidiary of
WorldCom (the "Intermedia -- WorldCom Merger"). As a result of the merger,
WorldCom will beneficially own a majority of the capital stock of Digex and will
have voting control of Digex. The Federal Communications Commission approved the
merger between WorldCom and Intermedia in January 2001 on the condition it
comply with an agreement reached with antitrust authorities that WorldCom divest
certain Intermedia assets and operations.
On February 15, 2001, WorldCom, Intermedia and Digex announced a proposed
settlement (the "Litigation Settlement") of a lawsuit arising out of WorldCom's
planned acquisition of a controlling interest in Digex through the
Intermedia -- WorldCom Merger. Certain of our minority shareholders brought suit
to enjoin the merger or to invalidate the approval of the transaction by our
Board of Directors. The proposed settlement would, if approved by the Delaware
Chancery Court, fully resolve all claims in the lawsuit and permit the
Intermedia -- WorldCom Merger to proceed. See Item 3 Legal Proceedings to Part I
of this Form 10-K for the principal terms of the proposed settlement with
respect to Digex.
On March 2, 2001, Digex entered into a definitive Stipulation of Settlement
with all relevant parties to settle all claims related to a consolidated class
action suit. The Court has entered its order directing that notice of the
settlement be sent to proposed class members and has scheduled a final hearing
to be held on April 6, 2001 in the Delaware Court of Chancery in Wilmington,
Delaware. The final settlement of the suit is subject to the satisfaction of
certain conditions as well as final court approval.
Also on March 2, 2001, Digex and certain subsidiaries of WorldCom entered
into four commercial agreements. These commercial agreements will become
effective at or before the consummation of the Intermedia -- WorldCom Merger
pursuant to the merger agreement. The principal terms of the four commercial
agreements are generally described as follows:
- Sales Channel Agreement. Under this agreement, WorldCom will resell the
Digex portfolio of managed Web hosting products. If Digex satisfies
certain service level commitments, WorldCom agrees to purchase up to a
total of $500.0 million during the period from 2001 through 2003. Digex
and WorldCom will share costs and profits generated from the WorldCom
sales channel. In November 2000, WorldCom announced the immediate U.S.
availability of an expanded global Web hosting product suite to include
high-end managed hosting services through arrangements with Digex. Digex
will also utilize WorldCom's sales force to enhance its global presence.
- Funding Agreement. After the completion of the Intermedia -- WorldCom
Merger, WorldCom's Board of Directors will review the Digex business
plans for 2001 and 2002 approved by the Digex Board of Directors. If
these business plans are approved by the WorldCom Board of Directors,
WorldCom agrees to loan Digex funds for these business plans; the loan
rate will be LIBOR plus 300 basis points. Repayment will be made over a
four-year period commencing in 2003. However, the funding agreement would
not prevent Digex from seeking replacement funding from other sources.
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- Facilities Agreement. Managed Web hosting facilities for Digex will be
built into existing WorldCom data centers in the United States and around
the globe. Digex will lease space from WorldCom at these data centers
based on customer demand.
- Network Agreement. This agreement permits Digex to purchase bandwidth
and connectivity from WorldCom in the United States to support its
managed Web hosting activities. Through the arrangement, Digex will be
able to connect its U.S. Internet data centers to the WorldCom global IP
network that runs through North America, South America, Europe, Asia, and
Australia with over 2,500 points of presence.
Other Significant Accomplishments
We have completed our first year of a three-year joint development project
with Compaq and Microsoft. In 2000, we hired an engineering team to work on the
next generation of hosting services as part of this joint development effort.
This development work is being done in the Digex Unified Lab, at the Microsoft
Partner Solutions Center in Redmond, WA and at the Compaq Labs in Houston, TX
enabling us to work directly with Microsoft and Compaq staff members on critical
engineering projects. We have created automated packages for Commerce,
Messaging, Database, and Application Management systems. These products and
services have enabled our customers to effectively conduct rapid deployments of
mission critical solutions. Lastly, we have developed ClientCentral(TM), a
management portal that allows customers to access customer-specific asset data,
billing information, performance statistics, and service ticket detail. The
ClientCentral trademark is currently pending final approval from the U.S. Patent
and Trademark Office.
In May 2000, we created European operating entities to support our
international operations and opened our first data center outside of the United
States. Located in London, our European SmartCenter(SM) gives Digex customers in
Europe the superior level of technology, security, and support services in
Europe they have come to rely on in the United States. The data center is a
leased facility which became operational in July 2000.
In January 2001, we received a $3.0 million loan from the State of Maryland
Department of Business and Economic Development under the Sunny Day Fund
initiative which may convert into a grant if certain conditions are met at
specific maturity dates.
Also, in January 2001, we were recently ranked by Gartner Research, a
leading industry research firm, as one of only two leaders on their North
American Web Hosting Magic Quadrant, and placed as the most visionary company in
the ranking.
We recently completed two rigorous assessments of our operating
environment. These assessments included a Type II review based on the American
Institute of Certified Public Accountants (AICPA)'s Statement on Auditing
Standards No. 70 (SAS70), and the Ernst & Young Cyber Process Certification.
These reviews examined Digex's managed data center facilities in three locations
in the United States and the United Kingdom. SAS70 was established by the AICPA
to provide a basis for examinations of the internal controls of service
organizations related to financial transaction processing. Digex had
successfully completed a SAS70 Type I review in May 2000. The Type II
review -- which requires testing of controls by the auditing firm -- was
conducted by Ernst & Young for the period July 1, 2000 through December 31,
2000. Also, Ernst & Young's Cyber Process Certification evaluated and tested the
design and operational effectiveness of controls to achieve the objectives
specified in the report, related to Digex's Web hosting services. Both reviews
focused on the control environment which govern the company's; (1) physical
security, (2) electronic security measures, (3) customer server infrastructure,
implementation, and maintenance, (4) network services and problem management,
and (5) business continuity. In February 2001, we successfully completed the
Type II review and the Cyber Process Certification for the six month period July
1, 2000 to December 31, 2000.
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INDUSTRY BACKGROUND
INTRODUCTION
Use of the Internet, including intranets and extranets, has grown rapidly
in recent years. This growth has been driven by a number of factors, including
the large and growing installed base of personal computers, improvements in
network architectures, increasing numbers of network-enabled applications, the
emergence of compelling content and commerce-enabling technologies, and easier,
faster and cheaper Internet access. As a result of this growing use, the
Internet has become an important new global communications and commerce medium.
The Internet represents an opportunity for enterprises to interact in new and
different ways with both existing and prospective customers, employees,
suppliers and partners. Enterprises are responding to this opportunity by
substantially increasing their investment in Internet sites and services.
Over the last few years, enterprises that focus solely on distributing
products and services over the Internet have emerged and, more recently,
mainstream businesses have begun to implement Web sites to complement
traditional business models and applications. Among the various factors which
continue to attract these businesses to the Internet is the transformation of
Web sites from being primarily text-based and informational to becoming
interactive, multimedia-enabled and transaction oriented. New technologies and
development tools have also led to the Web-enabling of traditional business
functions and applications such as customer service, procurement, human resource
management and sales force automation. Internet operations and applications are
mission-critical for virtually all Web-centric companies and are becoming
increasingly mission-critical for many mainstream enterprises. At the same time,
these operations and applications are becoming more complex and challenging to
operate. Ensuring the quality, reliability, and availability of these Internet
operations typically requires substantial investments in developing Internet
expertise and infrastructures. However, such a continuing significant investment
of resources is often an inefficient use of an enterprise's limited resources.
As a result, businesses are increasingly seeking collaborative outsourcing
arrangements that can increase performance, provide continuous operation of
their Internet solutions, and reduce Internet operating expenses.
According to Forrester Research in May 2000, 44% of the Global 2500 firms
they surveyed have outsourced the management of their Web sites. Forrester
reports that companies outsource Web site management primarily for the following
reasons:
- scarcity of technical skills;
- performance; and
- speed of implementation
We believe additional benefits of outsourcing the management of a complex
Web site include lower total costs, higher service level guarantees, higher
security levels and reduced risk of technology obsolescence.
EMERGENCE OF WEB HOSTING SERVICE PROVIDERS
In order to establish a high quality, reliable Web site or to run a
Web-based application on the Internet, businesses must, among other things,
procure and integrate sophisticated hardware and software, hire and retain an
operations support staff, develop application specific technical skills, and
have access to a secure, fault-tolerant physical location and redundant Internet
connectivity. While it is possible for a business to assemble all of these
elements in-house, many companies elect to outsource all or a portion of their
Web-site operations to companies offering Web hosting services. Web hosting
companies, in general, provide various infrastructure-related services,
including secure, monitored data centers, uninterrupted power supply and high-
speed network connectivity. We categorize the market for outsourced Web hosting
services into the following:
- Shared Hosting: Customers share server hardware, software and
bandwidth with other customers. Shared hosting provides a price
competitive entry point for individuals and businesses desiring a
simple Web site.
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- Collocation Hosting: Customers own their hardware, software and
network equipment, which is housed at the Web site hosting company's
facilities. The customers retain responsibility for the
installation, management, upgrading and security of their Web sites.
While collocation requires the customer to assume the majority of
the responsibilities for the operation of its Web site, collocation
has been and remains an attractive option for Web-centric companies
with advanced in-house Internet expertise.
- Dedicated Hosting: Customers are provided a complete managed Web
site hosting solution. Unlike collocation, the service provider
supplies the hardware, software, network equipment and support
necessary to run the Web site. In addition, dedicated hosting often
includes value-added services such as firewall management, stress
testing and consulting services. As Web sites have become more
complex, even large and technically astute businesses have found
Internet technologies and solutions a challenge to manage. For such
companies, including many Fortune 2000 companies, dedicated Web site
hosting has become a preferred alternative.
- Application Hosting: Application service providers deliver
Web-enabled business applications to their end-users over the
Internet, supporting such common business processes as customer
service, procurement, human resource management and sales force
automation. Often, an application service provider partners with a
dedicated hosting provider to bundle the services of dedicated web
hosting -- known as "application hosting" when targeted at this
market -- with their application services and support. Through this
partnership, the application service provider typically experiences
numerous benefits, including faster time-to-market, access to
advanced application skills and significantly lower costs of
operations.
A variety of companies, such as Internet service providers and large
systems integrators, offer products and services that attempt to address
enterprises' Internet outsourcing needs. However, we believe the solutions
offered by these companies fail to address certain elements required to ensure
that customers' mission-critical Internet operations are reliable, scalable and
responsive. Internet service providers, commonly referred to as ISPs have
traditionally focused on providing Internet access and many have not developed
the technical expertise and physical resources to support mission-critical Web
sites and applications. In addition, many large systems integrators focus
primarily on large enterprises and traditional information technologies. These
firms often lack the network and Internet expertise required to provide
mission-critical solutions. As a result, we believe a significant opportunity
exists for a highly-focused company to provide a combination of complex Web site
hosting, outsourced applications management and professional consulting services
that enable businesses to implement reliable, high performance and cost
effective mission-critical Internet solutions.
DIGEX SOLUTION
We focus primarily on providing dedicated managed Web site and application
hosting services. Our core competency is developing and managing
mission-critical Web solutions for Fortune 2000 companies, Web-centric
businesses and application service providers. We believe we are uniquely
positioned to assist such businesses in optimizing the potential of the Internet
and their Internet-related applications by providing our customers with the
following key advantages:
A Comprehensive Suite of Web Site and Application Hosting Services. We
provide a suite of services that enable companies to conduct business on the
Internet. Using a large, multi-specialized technical staff of certified
engineers, and through the security and reliability of our state-of-the-art data
centers, we provide the services and expertise necessary to ensure secure,
scalable, high-performance operation of mission-critical Web sites and
applications 24 hours a day. These services include:
- Management services such as operating and supporting Windows- and
UNIX-based dedicated servers and intelligent networking services
such as load balancing and network caching;
- Enterprise services such as firewall management, stress testing,
customized Web site activity reporting, and enhanced security
services; and
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- Application hosting services such as application support for various
operating systems, web servers, directory servers, database servers,
application servers and commerce suites.
- Consulting services including capacity planning, migration planning
and database optimization.
As part of our services, we provide the installation and maintenance of
industry-leading hardware and software, core technical expertise, high-volume
backup and recovery systems and 24 hours a day monitoring by our network
operations center.
High-Performance Internet and Private Network Connectivity. We provide
high performance network connectivity services for our customers' Web sites as
well as direct private networking options for secure "back-end" network
connections to private corporate networks and information systems. Through our
network services agreements with WorldCom, Intermedia and Telia UK Limited, we
offer superior Internet connectivity that provides the following direct benefits
to customers:
- connectivity to a diversely redundant high-speed global network via
WorldCom, one of the world's leading telecommunications companies;
- use of all of WorldCom, Intermedia and Telia's public and private
peering relationships, permitting direct exchange of traffic with a
significantly large number of carriers and ISPs;
- use of all of WorldCom, Intermedia and Telia's regional direct
connections to major ISPs, dial-up carriers and content service
providers; and
- service level agreements guaranteeing high availability and
performance.
In addition to the Internet connectivity available through WorldCom and
Intermedia's backbone, we provide diversified connectivity from our data centers
to other major Internet backbones. We are also actively establishing and
maintaining our own public and private peering arrangements.
Digex also offers a broad array of intelligent networking services
including products and services from Akamai and Cisco Systems.
Responsive Customer Care and Technical Support. We strive to provide
superior customer service. This includes providing customers with 24-hours a day
direct access to a staff of over 470 customer care and technical support
personnel and our use of a variety of proactive monitoring services from our
state-of-the-art network operations center, which allows us to anticipate
potential problems or rapidly identify and remedy service interruptions. We
believe this level of customer support significantly differentiates Digex in the
marketplace.
At our network operations center, we monitor and report on the health of
servers, software, networks, and security devices managed by us through our
centralized server monitoring platform. The network operations center uses a
variety of technologies and tools, including the Aprisma Spectrum, Micromuse
Netcool, and SiteScope products, to ensure highest possible server availability
by monitoring a large volume of server resources such as CPU utilization, system
and application processes, log files, TCP ports and disk space, and security
devices, such as firewalls. In addition, the network operations center monitors
specific network devices, such as routers, switches and load balancing equipment
that are critical to the successful delivery of our hosting services.
Secure, Fault-Tolerant Data Centers. Our data centers have been engineered
to meet the highest expectations of our most demanding customers across our
target markets, including the particularly stringent requirements of the
financial services industry.
Our data centers contain multiple, freestanding computer rooms to provide
containment and isolation. Separate mechanical rooms are adjacent to each
computer room to house cooling and mechanical equipment, eliminating the
possible introduction of liquid into the computer room from equipment leakage.
We use redundant uninterruptible power supply systems and redundant diesel
generators to ensure that the power system is capable of maintaining power to
the data center in the event of any component failure. State-of-the-art physical
security has been implemented through tightly controlled security zones
requiring card key,
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personal identification number and biometric identification. Over 100
surveillance cameras record movement through the data centers and security
guards provide real-time roaming visibility. Cooling and environmental controls
for each data center are designed to monitor and ensure proper temperature and
humidity levels. Finally, all telecommunications connections enter the data
centers through multiple points from many service arrangements to ensure
continued operation of service without degradation in the unlikely event of a
cable cut or local carrier network outage.
Through our facilities agreement with WorldCom, Digex will commence
building managed Web hosting facilities into existing WorldCom data centers in
the United States and around the globe. Digex intends to lease space from
WorldCom at these data centers based on customer demand. These hosting
facilities will be patterned after Digex facilities in the U.S.
Recurring Monthly Fees. We provide our services for recurring monthly
fees, enabling our customers to predictably budget costs for Web and application
hosting services. These fees are typically contracted as part of one, two or
three-year agreements. These agreements often provide service level guarantees
and permit technology upgrades at any time during the life of a contract.
DIGEX STRATEGY
Our objective is to maintain our leadership position in the industry and
continue to shape and lead the global market for hosting complex Web sites and
applications. We intend to accomplish this by delivering secure, scalable,
high-performance Web site and application hosting solutions. Our business
strategy focuses on the following:
Expand Our Premier Web Hosting Capabilities. We have expanded the capacity
of our east and west coast data centers in addition to opening our first data
center in Europe. We are actively seeking additional international expansion
opportunities. We intend to continue to add data center capacity over the next
five years as driven by customer demand. We believe our ability to readily grow
and scale our operations while simultaneously maintaining the highest service
levels will allow us to continue to attain higher revenues, lower marginal unit
costs and higher operating margins. The following are among the key initiatives
we have instituted to maintain the quality and scalability of our operations:
- We have formed alliances with leading technology companies. These
alliances help facilitate continuous innovation particularly in the
areas of Web solution scalability, serviceability and rapid
deployment. In January 2000, Microsoft and a subsidiary of Compaq
invested $100.0 million in Digex, of which $85.0 million was paid in
cash and $15.0 million was paid in the form of equipment credits
from Compaq. We also entered into strategic development agreements
with both companies to advance our capabilities to more rapidly
install, manage and upgrade large numbers of Microsoft Windows-based
servers and to streamline the order, delivery and installation of
Compaq hardware and storage devices.
- Our technical staff includes over 200 Microsoft certified engineers,
as well as technical experts certified by Cisco Systems and Sun
Microsystems. We believe this makes our technical staff among the
most highly skilled and trained in the Web hosting industry. Based
on comments by our customers, we believe our technical staff affords
us a competitive advantage and has been instrumental in attracting
many of our Fortune 2000 customers. In addition, we believe the
depth and scope of our staff's technical skill base is essential to
our ability to maintain our high quality service levels. To attract
and retain these individuals, we offer competitive financial
incentives, including in-house and external training programs, the
opportunity to work with cutting-edge technology, and stock options.
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Develop Next Generation Service Offerings. As the underlying technology
and functionality of Web-based products evolve, we believe customers will
continuously demand new service offerings. We believe the depth of our Web site
management skills positions us to be a leading provider of next generation Web
site and application hosting services. The following are among the new service
initiatives we are currently pursuing:
- Support for Leading Applications and Databases. We have developed
expertise in several of the leading software applications and
databases used by many of today's business-oriented Web sites. Over
the past year, Digex has begun to support solutions on the Windows
2000 platform and the Microsoft suite of .NET Enterprise Servers. We
also have standardized our UNIX solutions on the Solaris 8 platform
and offer full support for the iPlanet suite of Web and application
servers. We intend to continue to add new Web site applications and
databases to the list of software that we support.
- Value-added, Recurring Services. We have developed various
value-added services, which we believe significantly enhance the
availability and effectiveness of our customers' Web sites. Examples
of these services are: testing, security, database, reporting and
intranet service offerings. We intend to continue developing
services that improve the effectiveness of Web sites and optimize
their performance.
Expand Capabilities Through Selective Strategic Alliances and
Acquisitions. We currently have business alliances with over 100 Web design and
development companies and interactive media agencies. These businesses typically
partner with us due to our high quality services support and augment, rather
than compete with, their own product and service offerings. Together with our
business partners, we can provide our customers with end-to-end Web site
solutions. The Digex e-Link Partner Program(TM), continues to attract leading
interactive media and Web development companies such as Agency.com, Proxicom,
Rapidigm, Rare Medium, and Zefer. The Digex app-Link Partner Program(TM) expands
our alliances to include systems integrators, value-added resellers and
consultants who offer application services to customers over the Internet. Our
partnership programs provide a valuable, cost-effective channel for marketing
our services as well as a highly productive customer referral source. In
addition, we may seek to opportunistically acquire companies which we believe
will enable us to cost-effectively augment our existing products and services,
technology, infrastructure, skill set, geographic presence or customer base.
Our commercial agreements with WorldCom will allow Digex to purchase
bandwidth and connectivity from WorldCom in the United States and around the
globe to support our managed Web hosting activities. Through the arrangements,
Digex will be able to connect its Internet data centers in the U.S. to the
WorldCom global IP network that runs through North America, South America,
Europe, Asia, and Australia with over 2,500 points of presence.
DIGEX SERVICES
We offer a full range of complementary value-added services designed to
satisfy the rapidly evolving requirements of complex Web sites. Our services
include the following:
- Managed Hosting Services;
- Enterprise Services;
- Application Hosting Services; and
- Consulting Services.
MANAGED HOSTING SERVICES
Dedicated Web Site and Application Hosting Services. We offer dedicated
Web site and application hosting services designed to enable reliable, scalable,
mission-critical Web solutions. We operate both Windows- and UNIX-based servers
using hardware from Compaq and Sun Microsystems. By standardizing around the
hardware produced by these two vendors, we are able to quickly, easily and
cost-effectively upgrade, configure and implement the new hardware necessary to
accommodate our customers' growing needs
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for higher computing speeds and capacity. We offer a number of services to
dedicated Web site management customers and application service providers to
ensure ease of implementation, security, performance and scalability. We offer a
comprehensive package featuring our core managed hosting services under the
Digex SmartServices(SM) brand. Digex SmartServices(SM) include:
- installation and maintenance of Web sites and applications on
industry leading server hardware and applications;
- installation and maintenance of Microsoft Windows NT or Microsoft
Windows 2000 and/or the Sun Solaris UNIX operating system tested and
configured by us to ensure optimal Internet performance and
security;
- unlimited help desk support available 24 hours a day with access to
certified technical professionals;
- continuous server and network monitoring services;
- substantial inventory of parts on-site for rapid upgrading and
maintenance of hardware and software;
- industry and vendor security alerts and maintenance;
- backup and recovery of system information, user information and
customer content to ensure protection against data loss from
disaster, hardware failure, or administrative errors; and
- secure remote administration capabilities for easy and ubiquitous
remote management.
Intelligent Networking. We offer a variety of intelligent networking
services to our customers. These services include load balancing and
geographical distribution of network traffic using Cisco Systems technology and
high-performance delivery of Internet content using the Akamai network and
technology. We expect demand for these products to increase as more customers
move to multiple server and higher bandwidth solutions.
Private Networking. Our private networking services are primarily used to
securely connect a customer's Web site at our site to their private corporate
network or information system. Today, we offer a variety of management options
for private line and virtual private network services.
ENTERPRISE SERVICES
Our enterprise services help companies deploy and maintain effective Web
sites. We believe these value-added, repeatable services will become
increasingly important to our customers as they look to ensure a higher level of
Web site availability, security and reporting. Our enterprise services include
the following:
Reporting Services. Our reporting services are designed to provide timely,
reliable information about user activity on a customer's Web site. Businesses
can use these reports to assess the effectiveness of their Web sites and to
increase their knowledge of the preferences, habits and demographic
characteristics of their Web site visitors. For example, we offer a custom Web
site usage reporting service to help improve Web server performance for our
customers by off-loading the usage reporting processing to a powerful server
designed specifically for reporting.
Security Services. Our security services are designed to ensure the
security of a customer's Web site or applications. In December 2000, we
introduced security audits and security incident response services to provide
our customers with a higher level of protection and assurance. Other security
services offered today include security scanning and vulnerability assessment
services, managed and high availability firewalls, encryption software and
authentication devices.
Database Services. Our database services provide the installation,
configuration, maintenance and support of leading databases. Today, we provide
enhanced database services including those for Microsoft SQL Server 2000 and
Oracle 8i database technology.
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High Availability Services. We offer high-performance solutions at the
network, server and application layers, with products and Web architectures that
are built for speed. Our service offers address every aspect of a customer's Web
site, including content delivery, transaction processing and database
processing. In October 2000, we introduced Digex Intelligent Director, a
solution based on Layer 7 switching. This solution uses an array of logical
elements to decide how to balance the workload and provide preferred access to
selected servers.
Testing Services. Our testing services aim to identify problems that could
degrade the expected performance and availability of a customer's Web site. For
example, our stress testing services simulate users accessing a Web site to
provide information for isolating problems, optimizing performance and
accelerating the deployment of Web sites.
APPLICATION HOSTING SERVICES
Digex provides support for a variety of applications, which are necessary
to build and run a successful Web site. For each platform (Sun Solaris and
Microsoft Windows) we provide equivalent product sets, allowing us to provide
parallel levels of service regardless of the platform our clients wish to run.
Each application is incorporated into an automated Digex Build that has been
optimized for the application. This automated build ensures that each
installation is reliable and can be completed in a minimum amount of time over a
maximum number of servers. We support applications for various operating
systems, web servers, directory servers, database servers, application servers
and commerce suites.
Operating Systems. The Digex Build begins with the O/S layer which has
been engineered for maximum security, reliability and scalability. We have
standardized upon Windows NT4 and 2000 for Compaq servers and Sun Solaris 2.6
and 2.8 for Sun Servers.
Web Servers and Directory Servers. On the Windows platform we support
Microsoft Internet Information Server for NT4 and Windows 2000. For Directory
Services, we support Primary and Backup Domain Controllers for NT4
configurations and Active Directory for Windows 2000 implementations. On the Sun
Solaris platform we offer iPlanet Webserver and iPlanet Directory Server which
offer equivalent capabilities to the Microsoft Windows services.
Database Servers. For Microsoft Windows we support Microsoft SQL Server 7
and SQL 2000 database products. On the Sun Solaris platform we support Oracle 8i
and have begun work on Oracle 9i. Additionally, we provide High Availability
database solutions on both platforms: SQL 2000 Dynamic Failover for Windows, and
Oracle 8i Dynamic Failover for Solaris.
Application Servers and Commerce Suites. Our primary commerce products on
Windows are Microsoft Site Server Commerce Edition for NT4 and Microsoft
Commerce 2000 for Windows 2000. On the Sun Solaris platform we support iPlanet
Application Server 6.0. Support for both BEA Weblogic ATG Dynamo, and IBM
Websphere applications is provided. Given the large number of commerce products,
we carefully select those that have a solid market share advantage and technical
superiority. We will continue to add products to this list as market
opportunities dictate.
CONSULTING SERVICES
Our consulting services provide customized assistance to customers with
unique architecture, deployment or maintenance requirements. These services
include high-availability design, performance tuning, site architecture
assessment, migration planning, capacity planning, and database optimization.
Our consulting services typically assist customers with limited resources or who
lack Internet and technical expertise. Our consulting engagements typically
range from a few hours to a few weeks depending on the complexity and volume of
the services needed. We believe our consulting services will play an
increasingly important role in supporting the implementation and maintenance of
complex Web sites and Web-based applications.
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CUSTOMERS
We have a large and diverse customer base ranging from Fortune 50 companies
to small and medium size businesses that rely heavily on the Internet. Our
customers are primarily located within the United States. We serve over 600
customers, covering most major industries. Our customer contracts typically
range in duration from one to three years. Our customers include the following
well-known companies:
FINANCIAL SERVICES
AND INSURANCE MEDIA AND ENTERTAINMENT MANUFACTURING RETAIL AND DISTRIBUTION
- ------------------ ----------------------- ------------- -----------------------
American Century Investments Edmunds.com Clorox American Eagle Outfitters
Blue Shield of California McGraw Hill Companies Kraft Foods Hammacher Schlemmer & Co., Inc.
Fleet Credit Card Services Reader's Digest Philip Morris J. Crew
TECHNOLOGY AND
COMMUNICATIONS HEALTHCARE TRAVEL & HOSPITALITY
- -------------- ---------- --------------------
Alcatel Canada American Dental Association Thomas Cook
Compaq Association of American Medical Colleges Trans World Airlines
Hughes Software Systems DuPont Pharmaceuticals United Airlines
In the past few years, our growth has come from new customers, as well as
existing customers whose Web sites have become increasingly more strategic to
their overall business goals and objectives.
SALES AND MARKETING
Our sales objective is to achieve broad market penetration by focusing on
market segments that, we believe, have both a high propensity to outsource and
to deploy complex, mission-critical Web sites. We sell our services directly
through a highly skilled professional sales force and receive referrals through
an extensive network of business partners.
Direct Sales. As of December 31, 2000, our direct sales force consisted of
125 quota-bearing sales representatives. We have organized the sales force into
three units: major accounts, mid-market/Web-centric, and alternate channel. The
major accounts unit focuses on Fortune 2000 companies as well as certain
companies in the financial services, healthcare, publishing/media, and
technology sectors. The mid-market/ Web-centric unit addresses the large and
growing number of mid-size businesses requiring mission-critical hosting
services. Our alternate channel sales group works closely with our extensive
network of business alliance partners, which includes systems integrators, Web
site developers and application service providers. Supporting each of these
units is a site engineering team that provides pre-sales technical support,
including requirements gathering, configuration support, site architecture, and
project management.
Business Alliance Partners -- The Digex e-Link Partner Program(TM) and
Digex app-Link Partner Program(TM). In 1998, we created the Digex e-Link
Partner Program(TM) which, we believe, has attracted some of the leading
interactive media and Web site development companies to partner with us. To
date, our business partners include companies such as Agency.com, Rapidigm, Rare
Medium, and Zefer. We currently have over 100 business alliances that are a
significant source of sales leads and opportunities. These business partners
include Web site developers, Web site designers, interactive and new media
agencies, and systems integrators. We collaborate, instead of compete, with our
partners and complement each other's skills in an effort to bring the best
overall solution to our customers. Typically, in these collaborative
relationships, we focus on Web site hosting, while our strategic partners
concentrate on Web site design, development and systems integration.
In November 1999, we launched our second comprehensive partner program, the
Digex app-Link Partner Program(TM). The Digex app-Link Partner Program(TM)
targets application service providers, including consultants, systems
integrators and software developers. We currently host Web-based applications
for a variety of application service providers who specialize in providing a
broad range of Web-based business solutions.
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Marketing. Our marketing organization is responsible for building our
brand awareness, identifying key target markets and developing innovative
programs to communicate our products and services to the marketplace. Another
objective of our marketing efforts is to stimulate the demand for our services
through a broad range of marketing communications and public relations
activities. Our primary communication vehicles include advertising, trade shows,
direct response programs, event sponsorship, our Web sites and the distribution
channels of our technology vendors such as Microsoft, Compaq and Sun
Microsystems. Through our alliances with Microsoft and Compaq, we intend to
develop joint marketing activities promoting Windows-based solutions to Web site
and application service provider customers.
COMPETITION
The market served by Digex is highly competitive. There are few substantial
barriers to entry, and we expect to face additional competition from existing
competitors and new market entrants in the future. The principal competitive
factors in this market include:
- quality of services and scalability of infrastructure;
- network capacity, reliability, security and adaptability to new
technologies;
- Internet system engineering expertise;
- quality of customer service and support;
- relationships with marketing partners and vendors;
- number and geographic presence of sales and technical support personnel;
- variety of services offered;
- price;
- product innovation;
- financial resources; and
- brand name.
Our current and potential competitors in the market include:
- Web hosting service providers;
- local, regional, national and international ISPs;
- local, regional, national and international telecommunications companies;
and
- large information technology outsourcing firms.
Our competitors may operate in one or more of these areas and include
companies such as AT&T, Cable & Wireless, Data Return, EDS, Exodus
Communications, Globix, Genuity, IBM, Intel, Level 3 Communications, NaviSite,
and Qwest Communications International.
We believe our experience and reputation for delivering high quality,
managed Web site and application hosting services differentiates us from our key
competitors. We focus on our core competency of Web site and application hosting
as opposed to offering hosting as a complement to a wide range of communication
services. We believe we have defined and offer the industry's most complete set
of functions required to configure, engineer, implement and maintain complex,
transactional Web sites and applications. We believe our data centers and
technical team distinguish us from our competition and enable us to provide
among the highest quality end-to-end managed Web site and application hosting
solutions.
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INTELLECTUAL PROPERTY RIGHTS
We rely on a combination of copyrights, trademarks, service marks, patents,
trade secrets and contractual obligations to establish and protect certain
proprietary rights in our data, applications and services. Despite our efforts
to protect our proprietary rights, unauthorized parties may attempt to copy or
otherwise obtain and use our data or technology. In addition, the laws of
various foreign countries may not protect our products, services or intellectual
property rights to the same extent as do the laws of the United States.
We also rely on certain technologies we license from third parties, such as
Microsoft, Netscape and Micromuse. There can be no assurance these third-party
technology licenses will continue to be available to us on commercially
reasonable terms. The loss of such technology could require us to obtain
substitute technology of lower quality or performance standards or at greater
cost, which could harm our business. However, other than our trademarks and
service marks, we do not believe that the loss of any particular one of our
intellectual property rights would materially harm our business.
GOVERNMENT REGULATION
In the United States and most countries in which the Company conducts its
major operations, we are generally not regulated other than pursuant to laws
applicable to businesses in general or to value-added telecommunications
services specifically. In some countries, we are subject to specific laws
regulating the availability of certain material related to, or to the obtaining
of, personal information. Adverse developments in the legal or regulatory
environment relating to the Internet industry in the United States, Europe or
elsewhere could have a material adverse effect on our business, financial
condition and operating results.
In October 1998, Congress enacted the Digital Millennium Copyright Act,
which includes a limitation on liability of on-line service providers for
copyright infringement for transmitting, routing, or providing connections,
transient storage, caching or storage at the direction of a user. This
limitation on liability applies if the service provider had no actual knowledge
or awareness that the transmitted or stored material was infringing and if
certain other conditions are met. Since this law is relatively new, it remains
to be seen how the law will be applied to limit liability we may face in the
future for any possible copyright infringement or copyright-related issues. This
law also requires ISPs to follow certain "notice and take-down" procedures in
order to be able to take advantage of the limitation on liability. We have
implemented such procedures. Digex has a formal notification process, whereby we
notify an alleged infringer that we have a complaint, we notify the complainant
about the status, we investigate the matter internally, and if necessary,
suspend the infringer's use of Digex services and products until there is
resolution of the matter. The Digex Acceptable Use Policy Board seeks to respond
quickly to complaints that would fall under the scope of the Digital Millenium
Copyright Act. There is no assurance that our process and acceptable use policy
will shield us from liability but we have made a significant effort to meet the
process. Our customers are subject to an acceptable use policy which prohibits
them from posting, transmitting or storing material on or through any of our
services which, in our sole judgment, is (1) in violation of any local, state,
federal or foreign law or regulation, (2) threatening, obscene, indecent or
defamatory or that otherwise could adversely affect any individual, group or
entity or (3) in violation of the intellectual property rights or other rights
of any person.
Despite enactment of the Digital Millennium Copyright Act, the law relating
to the liability of on-line services companies and Internet access providers for
information carried on or disseminated through their networks remains largely
unsettled. It is possible claims could be made against on-line services
companies and Internet access providers under both United States and foreign law
for defamation, obscenity, negligence, copyright or trademark infringement, or
other theories based on the nature and content of the materials disseminated
through their networks. Several private lawsuits seeking to impose such
liability upon on-line services companies and Internet access providers are
currently pending.
The Child Online Protection Act of 1998 imposes criminal penalties and
civil liability on anyone engaged in the business of selling or transferring
material that is harmful to minors, by means of the World Wide Web, without
restricting access to this type of material by underage persons. Numerous states
have adopted or are currently considering similar types of legislation. The
nature of this and future legislation and the manner in which they may be
interpreted and enforced cannot be fully determined and could subject us and/or
our
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customers to potential liability, which in turn could harm our business. The
adoption of any of these types of laws or regulations might decrease the growth
of the Internet, which in turn could decrease the demand for our services or
increase our cost of doing business or in some other manner harm our business.
A number of legislative and regulatory proposals from various international
bodies and foreign and domestic governments in the areas of telecommunications
regulation, particularly related to the infrastructures on which the Internet
rests, access charges, encryption standards and related export controls, content
regulation, consumer protection, advertising, intellectual property, privacy,
electronic commerce, and taxation, tariff and other trade barriers, among
others, have been adopted or are now under consideration. We are unable at this
time to predict which, if any, of the proposals under consideration may be
adopted and, with respect to proposals that have been or will be adopted,
whether they will have a beneficial or an adverse effect on our business,
financial condition and operating results. The vast majority of such laws were
adopted prior to the advent of the Internet and related technologies and, as a
result, do not contemplate or address the unique issues of the Internet and
related technologies.
Moreover, the manner in which existing domestic and foreign laws (including
Directive 95/46/EC of the European Parliament and of the European Council on the
protection of individuals with regard to the processing of personal data and on
the free movement of such data) will or may be applied to online service and
Internet access providers is uncertain, as is the effect on our business given
different possible applications. Similarly, we are unable to predict the effect
on us from the potential future application of various domestic and foreign laws
governing content, export restrictions, privacy, consumer protection, export
controls on encryption technology, tariffs and other trade barriers,
intellectual property and taxes.
EMPLOYEES
As of January 1, 2001, we employed approximately 1,315 full-time employees.
None of our employees are covered by a collective bargaining agreement. We
believe that our employee relations are good.
RISK FACTORS
WE HAVE A LIMITED OPERATING HISTORY AND OUR BUSINESS MODEL IS STILL EVOLVING,
WHICH MAKES IT MORE DIFFICULT FOR YOU TO EVALUATE OUR COMPANY AND ITS PROSPECTS.
We were established in January 1996 to provide Web site hosting services
for businesses deploying complex, mission-critical Web sites, which remains our
primary focus. Our range of service offerings has changed since 1996 and our
business model is still new and developing. Because some of our services are
new, we cannot be sure that businesses will buy them. As a result, the revenue
and income potential of our business is unproven. Our limited operating history
makes predicting future results difficult. Our prospects must be considered in
light of the risks, expenses and difficulties encountered by companies in the
new and rapidly evolving market for Web site and application hosting services.
To address these risks, among other things, we must:
- provide reliable, technologically current and cost-effective
services;
- continue to upgrade and expand our infrastructure;
- market our brand name and services effectively;
- maintain and develop our business alliances; and
- retain and attract qualified personnel.
WE HAVE A HISTORY OF SIGNIFICANT LOSSES AND EXPECT THESE LOSSES TO CONTINUE IN
THE FORESEEABLE FUTURE.
We have experienced operating losses and negative cash flows from
operations in each annual period from inception. As of December 31, 2000, our
accumulated losses amounted to approximately $195.9 million. We had net losses
of $143.1 million for the year ended December 31, 2000. While our revenues have
grown in recent periods, we cannot assure you this growth will continue. In
connection with our expansion plans, we
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anticipate that we will continue to make significant investments in sales,
marketing, technical and customer support personnel, as well as in our data
center infrastructure. As a result of our expansion plans, we expect our net
losses and negative cash flows from operations to continue for the foreseeable
future. We cannot assure you that we will ever become or remain profitable or
that we will generate positive cash flows from operations.
OUR QUARTERLY AND ANNUAL RESULTS MAY FLUCTUATE, RESULTING IN FLUCTUATIONS IN THE
PRICE OF OUR CLASS A COMMON STOCK.
Our results of operations fluctuate on a quarterly and annual basis. We
expect to continue experiencing fluctuations in our future quarterly and annual
results of operations due to a variety of factors, many of which are outside our
control, including:
- demand for and market acceptance of our services;
- introductions of new services by us and our competitors;
- capacity utilization of our data centers;
- timing of customer installations;
- the mix of services we sell;
- customer retention;
- the timing and magnitude of our capital expenditures;
- changes in our pricing policies and those of our competitors;
- fluctuations in bandwidth used by customers;
- our retention of key personnel;
- reliable continuity of service and network availability;
- costs related to the acquisition of network capacity and
arrangements for interconnections with third-party networks;
- the provision of customer discounts and credits;
- the timing of expansion of existing data centers and completion of
new data centers, including obtaining necessary permits and adequate
public utility power;
- the introduction by third parties of new Internet and networking
technologies;
- licenses and permits required to construct facilities, deploy
networking infrastructure or operate in the United States and
foreign countries; and
- other general economic factors.
For these and other reasons, in some future quarters, our results of
operations may fall below the expectations of securities analysts or investors,
which could negatively affect the market price of our Class A Common Stock.
WE CANNOT PREDICT THE OUTCOME OF OUR JOINT DEVELOPMENT EFFORT WITH MICROSOFT AND
COMPAQ.
Working closely with Microsoft and Compaq, we expect to invest significant
resources to advance our ability to more rapidly install, manage and upgrade
large numbers of Microsoft Windows-based servers for Web site and application
hosting. While Microsoft and a subsidiary of Compaq have each made a $50.0
million equity investment in our company, neither has an obligation to
contribute additional equity, whether or not the costs associated with this
development project exceed our expectations. Our alliance agreements also do not
prevent Microsoft and/or Compaq from working with other service providers to
develop similar capabilities. In addition, because this alliance is for a
research and development project, we cannot assure you that any commercially
successful products will be developed as a result of our agreements with
Microsoft and
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Compaq. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Overview and Liquidity and Capital Resources."
WE OPERATE IN A RELATIVELY NEW AND EVOLVING MARKET WITH UNCERTAIN PROSPECTS FOR
GROWTH.
The market for Web site and application hosting and related services has
only recently begun to develop and is evolving rapidly. Although certain
industry analysts project significant growth for this market, their projections
may not be realized. Our future growth, if any, will depend on the continued
trend of businesses outsourcing their Web site and application hosting and our
ability to market our services effectively. There can be no assurance that the
market for our services will grow, that our services will be adopted, or that
businesses will use these Internet-based services to the degree or in the manner
that we expect. It is possible that at some point businesses may find it
cheaper, more secure or otherwise preferable to host their Web sites and
applications internally and decide not to outsource the management of their Web
sites and applications. If we are unable to react quickly to changes in the
market, if the market fails to develop, or develops more slowly than expected,
or if our services do not achieve market acceptance, then we are unlikely to
become or remain profitable.
WE MAY BE UNABLE TO ACHIEVE OUR OPERATING AND FINANCIAL OBJECTIVES DUE TO
SIGNIFICANT COMPETITION IN THE WEB SITE AND APPLICATION HOSTING INDUSTRY.
The market for hosting Web sites and applications is highly competitive.
There are few substantial barriers to entry and many of our current competitors
have substantially greater financial, technical and marketing resources, larger
customer bases, more data centers, longer operating histories, greater name
recognition and more established relationships in the industry than we possess.
Our current and potential competitors in the market include Web hosting service
providers, Internet service providers, commonly known as ISPs,
telecommunications companies and large information technology outsourcing firms.
Our competitors may operate in one or more of these areas and include companies
such as AT&T, Cable & Wireless, Data Return, EDS, Exodus Communications, Globix,
Genuity, IBM, Intel, Level 3 Communications, NaviSite, and Qwest Communications
International.
Our competitors may be able to expand their network infrastructures and
service offerings more quickly. They may also bundle other services with their
Web site hosting or application hosting services, which could allow them to
reduce the relative prices of their Web site hosting and/or application hosting
services beyond levels that we could compete with, and generally adopt more
aggressive pricing policies. In addition, some competitors have entered and will
likely continue to enter into joint ventures or alliances to provide additional
services which may be competitive with those we provide. We also believe the Web
site hosting and application hosting markets are likely to experience
consolidation in the near future, which could result in increased price and
other competition that would make it more difficult for us to compete. See
"Business -- Competition."
OUR DATA CENTERS AND THE NETWORKS WE RELY ON ARE SENSITIVE TO HARM FROM HUMAN
ACTIONS AND NATURAL DISASTERS. ANY RESULTING DISRUPTION COULD SIGNIFICANTLY
DAMAGE OUR BUSINESS AND REPUTATION.
Our reputation for providing reliable service largely depends on the
performance and security of our data centers and equipment, and of the network
infrastructure of our connectivity providers. In addition, our customers often
maintain confidential information on our servers. However, our data centers and
equipment, the networks we use, and our customers' information are subject to
damage and unauthorized access from human error and tampering, breaches of
security, natural disasters, power loss, capacity limitations, software defects,
telecommunications failures, intentional acts of vandalism, including computer
viruses, and other factors that have caused, and will continue to cause,
interruptions in service or reduced capacity for our customers, and could
potentially jeopardize the security of our customers' confidential information
such as credit card and bank account numbers. Despite precautions we have taken
and plan to take, the occurrence of a security breach, a natural disaster,
interruption in service or other unanticipated problems could seriously damage
our business and reputation and cause us to lose customers. Additionally, the
time and expense required to eliminate computer viruses and alleviate other
security problems could be significant and could
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impair our service quality. We also often provide our customers with service
level agreements. If we do not meet the required service levels, we may have to
provide credits to our customers, which could significantly reduce our revenues.
Additionally, in the event of any resulting harm to customers, our customers
might seek to hold us liable for damages. Awards for such damages might exceed
our liability insurance by an unknown but significant amount and could seriously
harm our business.
IF WE WERE UNABLE TO SECURE SUFFICIENT NETWORK CAPACITY TO MEET OUR FUTURE NEEDS
ON REASONABLE TERMS OR AT ALL, WE MIGHT NOT BE ABLE TO PROVIDE ADEQUATE SERVICE
TO OUR CUSTOMERS.
We must continue to expand and adapt our network arrangements to
accommodate an increasing amount of data traffic and changing customers'
requirements. We have entered into network services agreements with WorldCom,
Intermedia, and Telia to provide us with certain network transit capacity which
we believe to be adequate for our capacity requirements. However, if our future
network capacity requirements exceed the capacity WorldCom, Intermedia, and
Telia have committed to provide to us, we may have to pay higher prices for such
additional network capacity or such capacity might not be available at all. Our
failure to achieve or maintain high capacity data transmission could negatively
impact service levels to our existing customers and limit our ability to attract
new customers.
OUR BUSINESS, IN LARGE PART, DEPENDS ON NETWORK SERVICES WE RECEIVE FROM
WORLDCOM, INTERMEDIA, AND TELIA. ANY DISRUPTION OF THESE SERVICES OR THE NETWORK
PROVIDERS' INABILITY TO MAINTAIN ITS PEERING RELATIONSHIPS COULD BE COSTLY AND
HARMFUL TO OUR BUSINESS.
We currently rely primarily on WorldCom and secondarily on Intermedia for
network services in the U.S. We currently rely primarily on Telia for network
services in the U.K. Each of these providers qualifies as a tier-one service
provider of Internet connectivity services for their geographic capacities. If
any of these providers were unable to provide our network services or our
agreements were to be terminated, we would need to rapidly secure an alternative
provider of these services. As a result, we could incur transition costs and our
monthly costs of operations could increase. In addition, such a transition could
have a detrimental effect on our customer service levels.
The Internet is composed of many ISPs that operate their own networks and
interconnect with other ISPs at various peering points. Peering relationships
are arrangements that permit ISPs to exchange traffic with one another without
having to pay for the cost of transit services. Peering relationships are a
competitive factor that allow some Web hosting companies to provide faster data
transmission than others. We believe the tier-one status and numerous peering
relationships of WorldCom, Intermedia, and Telia enable them to provide us
faster data transmission than many other ISPs provide. If WorldCom, Intermedia,
or Telia fails to adapt its network infrastructure to meet industry requirements
for peering or loses its peering relationships for any other reason, then our
transmission rates could be reduced, resulting in a decrease in the service
quality we provide to our customers.
PROVIDING SERVICES TO CUSTOMERS WITH MISSION-CRITICAL WEB SITES AND WEB-BASED
APPLICATIONS COULD POTENTIALLY EXPOSE US TO LAWSUITS FOR CUSTOMERS' LOST PROFITS
OR OTHER DAMAGES.
Because our Web site and application hosting services are critical to many
of our customers' businesses, any significant interruption in our services could
result in lost profits or other indirect or consequential damages to our
customers. Our customers are required to sign server order forms which
incorporate our standard terms and conditions. Although these terms disclaim our
liability for any such damages, a customer could still bring a lawsuit against
us claiming lost profits or other consequential damages as the result of a
service interruption or other Web site or application problems that the customer
may ascribe to us. There can be no assurance a court would enforce any
limitations on our liability, and the outcome of any lawsuit would depend on the
specific facts of the case and legal and policy considerations. We also believe
we would have meritorious defenses to any such claims, but there can be no
assurance we would prevail. In such cases, we could be liable for substantial
damage awards. Such damage awards might exceed our liability insurance by
unknown but significant amounts, which would seriously harm our business.
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DIGEX IS CONTROLLED BY A CONTROLLING STOCKHOLDER WHICH COULD INVOLVE MULTIPLE
RISKS FOR YOU AS A STOCKHOLDER.
Intermedia controls (and, after completion of the Intermedia-WorldCom
Merger, WorldCom will control) a majority of our voting power, and our majority
stockholder's interests in us may conflict with your interests as a
stockholder. Intermedia, indirectly through its wholly-owned subsidiary,
Intermedia Financial Company, owns all of the issued and outstanding shares of
our Class B Common Stock. Intermedia currently owns 39,350,000 shares of Class B
Common Stock or approximately 61.6% of the outstanding capital stock of Digex.
Each share of Class B Common Stock is entitled to 10 votes, as compared to one
vote for each share of Class A Common Stock. As a result, Intermedia controls
approximately 94.1% of our voting interests, and controls the management and
affairs of Digex, and all matters submitted to our stockholders for approval,
including the election and removal of directors, and any merger, consolidation
or sale of all or substantially all of our assets. Upon completion of the
Intermedia-WorldCom Merger, WorldCom, through a wholly-owned subsidiary, will
own all of the issued and outstanding shares of Intermedia and therefore will
become our controlling stockholder. The price of our Class A Common Stock may be
affected as a result of us having a controlling stockholder.
Until the closing of the Intermedia-WorldCom Merger, we will depend on
Intermedia to fund our working capital and operating losses upon the depletion
of our cash resources, but Intermedia's ability to fund these needs is limited
by its own substantial indebtedness. Because we anticipate operating losses and
a significant need for working capital for the foreseeable future, we expect we
will have to obtain funds for such purposes from Intermedia or other sources.
Intermedia is and will continue to be highly leveraged and may incur
additional indebtedness in the future. Intermedia's level of debt will require
it to dedicate a substantial portion of its future cash flow from operations for
payment of principal and interest on its debt, as well as dividends on and the
redemption of its preferred stock. Historically, Intermedia has not generated
sufficient cash flow to cover its operating and investing expenses. In addition,
because of the restrictions in the Intermedia indentures, Intermedia has only a
limited amount of cash that may be used for working capital purposes and to fund
operating losses. Consequently, Intermedia may not be able to provide us with a
source of funds for our working capital or operating losses. The auditors of
Intermedia have expressed in their opinion that while Intermedia's consolidated
financial statements have been prepared assuming that it will continue as a
going concern, Intermedia has incurred recurring operating losses and has a net
capital deficiency, and as a result, these conditions raise substantial doubt
about Intermedia's ability to continue as a going concern. Our dependence on
Intermedia and the degree to which Intermedia is leveraged could, among other
things, increase our vulnerability to general adverse economic and industry
conditions, limit our ability to fund future working capital, operating losses,
capital expenditures, acquisitions and other requirements, and limit our
flexibility in reacting to changes in our business and industry. We strongly
urge you to read "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity and Capital Resources."
We may require additional funds to finance our business but our ability to
raise funds is significantly limited by agreements that are binding on
Intermedia. Intermedia has issued debt securities to the public under seven
indentures. In addition, as of December 31, 2000, Intermedia borrowed $113.0
million under a $350.0 million credit facility. Intermedia has entered into a
$225.0 million Note Purchase Agreement with WorldCom. Through Intermedia, we
expect the proceeds from these financings will be available to fund our
operations, working capital needs and capital expenditures as liquidity needs
arise.
As a subsidiary of Intermedia, we are currently subject to a number of
restrictions under the Intermedia indentures and the credit facility. These
restrictions will, among other things, limit our ability to make certain
restricted payments, incur indebtedness and issue preferred stock, pay dividends
or make other distributions, engage in sale and leaseback transactions, create
liens, sell our assets, issue or sell our equity interests, or enter into
certain mergers and consolidations. As a result, our future financing sources
may be significantly limited and our use of any proceeds of any future financing
may be significantly restricted.
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We, along with Intermedia's other subsidiaries, have guaranteed
Intermedia's obligations under its credit facility which could make us more
vulnerable to changes in Intermedia's financial condition and make it more
difficult for us to raise capital to expand our business. As security for our
limited guarantee, we have granted the banks a security interest in a
substantial portion of our assets. If Intermedia were unable to meet its
obligations under the credit facility, we could be obligated to repay the debt
at the greater of $90.0 million or the amounts borrowed by Digex. In addition,
the banks' liens on a substantial portion of our assets could make it more
difficult for us to obtain additional financing. The credit facility is also
fully guaranteed by WorldCom.
Our ability to issue additional capital stock is restricted by Intermedia's
merger agreement with WorldCom. Additionally, we are constrained by Intermedia's
ownership of the Class B Common Stock, which could make it more difficult for us
to raise capital to expand our business. In the future, Intermedia may elect to
sell additional shares of our Class B Common Stock to the public or to
distribute these shares to its own stockholders. If as a result of a sale or
distribution, Intermedia would no longer hold more than 50% of the total voting
power of our capital stock, the consent of the majority in principal amount of
the noteholders under the Intermedia indentures would be required for the sale
or distribution. In addition, if we decide in the future to issue and sell
additional shares of our capital stock and, as a result, the voting power
represented by the Class B Common Stock held by Intermedia would no longer be
greater than 50% of the total voting power of our capital stock, the consent of
the majority in principal amount of the noteholders under the Intermedia
indentures would be required for the sale. We would be free of the restrictions
in the Intermedia indentures only if either Intermedia's voting power was
reduced to below 50% as described above or Intermedia designated us as an
"unrestricted subsidiary," which would also require a consent of a majority in
principal amount of the noteholders under the Intermedia indentures.
THE FAILURE OF THE INTERMEDIA -- WORLDCOM MERGER TO CLOSE WOULD ADVERSELY IMPACT
US.
As described in "Business -- Recent Developments", we have entered into a
series of commercial arrangements with WorldCom that provide for the
establishment of a WorldCom sales channel, access of Digex to WorldCom data
centers for building managed Web hosting facilities and other arrangements that
we believe are very favorable to our business. In addition, after the completion
of the Intermedia -- WorldCom Merger, WorldCom has agreed to provide us with
funding for our 2001 and 2002 business plans that are approved by the Digex and
WorldCom board of directors. These favorable agreements are subject to
termination if, among other things, the Intermedia -- WorldCom Merger is not
completed prior to December 31, 2001. The Intermedia -- WorldCom Merger is
subject to a number of conditions, including the Litigation Settlement becoming
final and non-appealable. If for any reason the Intermedia -- WorldCom Merger
were not to close, we might no longer have the benefit of the WorldCom
commercial agreements or the funding to be made available by WorldCom for our
2001 and 2002 business plans. In addition, if the Intermedia -- WorldCom Merger
were not to close, Intermedia would no longer be able to borrow under its
existing credit facility or note purchase agreement with WorldCom and unlikely
be able to provide us with any additional monies to fund our working capital
needs, operating losses or expenditure requirements. We have had preliminary
discussions with third party sources regarding potential financing available to
us in this event and we expect that we will have sufficient access to capital
markets to provide the necessary funding. However, there can be no assurance
that such financing would be available to us or, if available, that the terms
would be as favorable to us as those that would be available if the
Intermedia -- WorldCom Merger were to close.
IF WE DO NOT RESPOND EFFECTIVELY AND ON A TIMELY BASIS TO RAPID TECHNOLOGICAL
CHANGE AND EVOLVING INDUSTRY STANDARDS, OUR BUSINESS COULD SUFFER.
Internet and networking technology is changing rapidly. Our future success
will depend largely on our ability to:
- offer services that incorporate leading technologies;
- address the increasingly sophisticated and varied needs of our current
and prospective customers;
- respond to technological advances and emerging industry standards on a
timely and cost-effective basis; and
- continue offering services that are compatible with products and
services of other vendors.
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Although we often work with various vendors in testing newly developed
products, there can be no assurance such products will be compatible with our
infrastructure or such products will adequately address changing customer needs.
Although we currently intend to support emerging standards, there can be no
assurance industry standards will be established or, if they become established,
that we will be able to conform to these new standards in a timely fashion and
maintain a competitive position in the market. Our failure to conform to the
prevailing standards, or the failure of common standards to emerge, could harm
our business. In addition, products, services or technologies developed by
others may render our services no longer competitive or obsolete.
OUR BUSINESS WILL NOT GROW UNLESS INTERNET USAGE GROWS AND INTERNET PERFORMANCE
REMAINS ADEQUATE.
The increased use of the Internet for retrieving, sharing and transferring
information among businesses and consumers has only recently begun to develop.
Our success will depend on the continued growth in Internet usage. In addition,
our business plan anticipates extensive growth in the Web site hosting and
application hosting markets. The growth of the Internet, including the Web site
hosting and application hosting markets, is subject to a high level of
uncertainty and depends on a number of factors, including the growth in consumer
and business use of new interactive technologies, the development of
technologies that facilitate interactive communications, security concerns,
increases in data transport capacity and general economic conditions. If the
Internet as a commercial medium fails to grow or develops more slowly than
expected, then our business is unlikely to grow.
The recent growth in the use of the Internet in general has caused frequent
periods of performance degradation, requiring the upgrade of routers and
switches, telecommunications links and other components forming the
infrastructure of the Internet by ISPs and other organizations with links to the
Internet. Any perceived degradation in the performance of the Internet as a
whole could undermine the benefits of our services. The performance of our Web
site and application hosting services is ultimately limited by and relies on the
speed and reliability of the networks operated by third parties. Consequently,
the growth of the market for our services depends on improvements being made to
the entire Internet infrastructure to alleviate overloading and congestion.
WE MAY BE UNABLE TO ACHIEVE OUR OPERATING AND FINANCIAL OBJECTIVES IF WE CANNOT
MANAGE OUR ANTICIPATED GROWTH EFFECTIVELY.
Our business has grown rapidly, and our future success depends in large
part on our ability to manage the recent and anticipated growth in our business.
For us to manage this growth, we will need to:
- expand and enhance our operating and financial procedures and
controls;
- replace or upgrade our operational and financial management
information systems; and
- attract, train, manage and retain key employees.
These activities are expected to place a significant strain on our
financial and management resources. If we are unable to manage growth
effectively, our business could suffer.
OUR GROWTH DEPENDS ON OUR ABILITY TO EXPAND DATA CENTER CAPACITY TO MEET
ANTICIPATED DEMAND.
Continuing to expand capacity is critical to achieving our business
strategy. This expansion is likely to include the need to add new hardware and
software, and may include the opening of additional data centers both in the
United States and globally. We recently expanded the capacity of our east and
west coast data centers in the United States and in Europe. We intend to add
data center capacity over the next five years as justified by customer demand.
Our ability to do so successfully depends on:
- anticipating and planning for future demand levels;
- having access to sufficient capital; and
- locating and securing satisfactory data center sites and implementing
the build-out of these sites, all of which may require significant
lead time.
If we cannot expand capacity effectively, our growth will suffer and we may
not be able to adequately meet the demands of existing customers.
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OUR BUSINESS COULD BE HARMED IF OUR MANAGEMENT TEAM, WHICH HAS WORKED TOGETHER
FOR ONLY A BRIEF TIME, IS UNABLE TO WORK TOGETHER EFFECTIVELY, OR IF WE ARE
UNABLE TO RETAIN AND ATTRACT KEY PERSONNEL.
We have recently hired key employees and officers, including our Senior
Vice President of Business Operations, Senior Vice President of Digex Europe,
and Senior Vice President and General Counsel in 2000 and our Senior Vice
President of Sales in March 2001. These key individuals will be working with our
President and Chief Executive Officer, President of Product Management,
Engineering and Marketing Group, and Chief Financial Officer, each of whom have
joined Digex for less than two years. As a result, our management team has
worked together for only a brief time. Our success in significant part depends
on the continued services of our senior management personnel, as well as of our
key technical and sales personnel.
We believe our short and long-term success also depends largely on our
ability to attract and retain highly skilled technical, managerial and marketing
personnel, particularly additional management personnel in the areas of
application integration and technical support. Competition for such personnel is
intense. We may not be able to hire or retain the necessary personnel to
implement our business strategy, or we may need to pay higher compensation for
employees than we currently expect. Our inability to attract and retain such
personnel would limit our growth and harm our business.
REGULATORY AND LEGAL UNCERTAINTIES COULD HAVE SIGNIFICANT COSTS OR OTHERWISE
HARM OUR BUSINESS.
Laws and regulations directly applicable to communications and commerce
over the Internet are becoming more prevalent. The United States Congress has
recently considered enacting Internet laws regarding children's privacy,
copyrights, taxation and the transmission of sexually explicit material. The
European Union also enacted its own privacy regulations. The law of the
Internet, however, remains largely unsettled, even in areas where there has been
some legislative action. It may take years to determine whether and how existing
laws such as those governing intellectual property, privacy, libel and taxation
apply to the Internet. In addition, the growth and development of the market for
online commerce may prompt calls for more stringent consumer protection laws,
both in the United States and abroad, that may impose additional burdens on
companies conducting business online. The application of existing laws or
promulgation of new laws could require us to expend substantial resources to
comply with such laws or discontinue certain service offerings. Increased
attention to liability issues could also divert management attention, result in
unanticipated expenses and harm our business. Regulation of the Internet may
also harm our customers' businesses, which could lead to reduced demand for our
services. We are not currently subject to direct regulation by the Federal
Communications Commission ("FCC") or any other government agency, other than as
to regulations applicable to business in general. However, in the future we may
be subject to regulation by the FCC or other federal or state agencies, which
could increase our costs and harm our business. See "Business -- Government
Regulation."
We provide services over the Internet in many states in the United States
and in many foreign countries, and we facilitate the activities of our customers
in these jurisdictions. As a result we may be required to qualify to do
business, or be subject to taxation, or be subject to other laws and
regulations, in these jurisdictions even if we do not have a physical presence
or employees or property in these jurisdictions. The application of these
multiple sets of laws and regulations is uncertain, but we could find that we
are subject to regulation, taxation, enforcement or other liability in
unexpected ways, which could materially adversely affect our business.
WE COULD BE HELD LIABLE FOR THE INFORMATION DISSEMINATED THROUGH OUR NETWORK.
The law relating to the liability of online services companies and Internet
access providers for information and commerce carried on or disseminated through
their networks is currently unsettled. The Child Online Protection Act of 1998
imposes criminal penalties and civil liability on anyone engaged in the business
of selling or transferring material that is harmful to minors, by means of the
World Wide Web, without restricting access to this type of material by underage
persons. Numerous states have adopted or are currently considering similar types
of legislation. The imposition upon us and other Internet network providers of
potential liability for information carried on or disseminated through systems
could require us to implement measures to reduce exposure to liability, which
may require the expenditure of substantial resources, or to discontinue various
service or product offerings. Further, the costs of defending against any claims
and potential adverse outcomes of these claims could have a material adverse
effect on our business. While we
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carry professional liability insurance, it may not be adequate to compensate or
may not cover us in the event we become liable for information carried on or
disseminated through our networks.
DIFFICULTIES PRESENTED BY INTERNATIONAL ECONOMIC, POLITICAL, LEGAL, ACCOUNTING
AND BUSINESS FACTORS COULD HARM OUR BUSINESS IN INTERNATIONAL MARKETS.
A component of our strategy is to expand into international markets. We
opened our first data center outside of the United States in the London
metropolitan area in July 2000. We plan to open additional international data
centers during 2001. We may also enter into joint ventures or outsourcing
agreements with third parties, acquire rights to high-bandwidth transmission
capability, acquire complementary businesses or operations, or establish and
maintain new operations outside of the United States. Thus, we may depend on
third parties to be successful in our international operations. In addition, the
rate of development and adoption of the Internet has been slower outside of the
United States, and the cost of bandwidth has been higher, which may adversely
affect our ability to expand operations and may increase our cost of operations
internationally. The risks inherent in conducting business internationally
include:
- unexpected changes in regulatory, tax and political environments;
- longer payment cycles and problems in collecting accounts receivable;
- fluctuations in currency exchange rates and imposition of currency
exchange controls;
- ability to secure and maintain the necessary physical and
telecommunications infrastructure;
- challenges in staffing and managing foreign operations; and
- employment laws and practices in foreign countries.
Any of these could adversely affect our international operations.
Furthermore, some foreign governments have enforced laws and regulations on
content distributed over the Internet that are more restrictive than those
currently in place in the United States. Any one or more of these factors could
adversely affect our contemplated future international operations and
consequently, our business.
THE GREATER VOTING POWER OF OUR CLASS B COMMON STOCK, AS WELL AS SOME PROVISIONS
OF THE DELAWARE ANTI-TAKEOVER LAW AND OF OUR CERTIFICATE OF INCORPORATION AND
BYLAWS, COULD DISCOURAGE A TAKEOVER OF DIGEX AND ADVERSELY AFFECT THE PRICE OF
THE CLASS A COMMON STOCK.
Our board of directors currently has the authority to issue an additional
4,900,000 shares of preferred stock and to determine the price, rights,
preferences, privileges and restrictions, including voting rights, of those
shares without any further vote or action by the stockholders. The rights of the
holders of any of our common stock may be adversely affected by the rights of
the holders of any preferred stock that may be issued in the future. The
issuance of preferred stock, while providing flexibility in connection with
possible acquisitions and other corporate purposes, could have the effect of
making it more difficult for a third party to acquire a majority of our
outstanding voting stock. We have no current plans to issue additional shares of
preferred stock and any issuance of preferred stock is subject to restrictions
under the Intermedia indentures.
We are also subject to certain provisions of Delaware law which could have
the effect of delaying, deterring or preventing a change in control of Digex,
including Section 203 of the Delaware General Corporation Law, which prohibits
us from engaging in any business combination with any interested stockholder for
a period of three years from the date the person became an interested
stockholder unless certain conditions are met. In addition, our certificate of
incorporation and bylaws contain certain provisions that, together with
Intermedia's voting power and ownership of Class B Common Stock, could
discourage potential takeover attempts and make attempts by stockholders to
change management more difficult. The terms of the Litigation Settlement are
structured so that Section 203 will not be applicable to any future transactions
between WorldCom and us. Although as part of the Litigation Settlement, WorldCom
has agreed to abide by certain procedures for certain affiliated transactions
for a three-year period, such procedures would not afford the same protections
as would Section 203 if it were applicable to such transactions.
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THIS REPORT INCLUDES FORWARD-LOOKING STATEMENTS, WHICH COULD DIFFER FROM ACTUAL
RESULTS.
Some of the statements in this Form 10-K that are not historical facts are
"forward-looking statements" (as such term is defined in the Private Securities
Litigation Reform Act of 1995). Forward-looking statements can be identified by
the use of words such as "estimates," "projects," "anticipates," "expects,"
"intends," "believes" or comparable terminology, the negative thereof or other
variations thereon or by discussions of strategy that involve risks and
uncertainties. Examples of forward-looking statements include discussions
relating to:
- plans to expand our existing Web site hosting services and application
hosting services;
- introductions of new products and services;
- proposals to build new data centers in various geographic areas;
- estimates of market sizes and addressable markets for our services and
products;
- estimates of future revenues; and
- statements regarding the future course of our relationship with
Intermedia and WorldCom.
We wish to caution you that all the forward-looking statements contained in
this document are only estimates and predictions. Our actual results could
differ materially from those anticipated in the forward-looking statements due
to risks, uncertainties or actual events differing from the assumptions
underlying these statements. Such risks, uncertainties and assumptions include,
but are not limited to, those discussed in this Form 10-K.
ITEM 2. PROPERTIES
We currently lease office space for our corporate headquarters,
administrative offices, and regional sales office in Laurel and Beltsville,
Maryland. Our local sales offices are located in leased office spaces in London,
New York City, San Jose and Los Angeles, California. We also lease facilities
for our east coast data center in Beltsville, our west coast data center in
northern California, and our European data center in London, United Kingdom.
As of December 31, 2000, our total property and equipment in service
consisted of buildings (6.6%), electronic and computer equipment (60.8%),
computer software (12.0%), furniture and office equipment (1.9%) and leasehold
improvements (18.7%). Such properties do not lend themselves to description by
character and location of principal units. Substantially all of our
telecommunications equipment is housed in multiple leased facilities on the east
and west coast. We believe that our properties are adequate and suitable for
their intended purposes.
DATA CENTER INFRASTRUCTURE
We presently operate highly secure, fault-tolerant data centers
specifically designed for the non-stop 24-hours a day hosting of Web sites and
Web-based applications. Our east coast data center is strategically located near
major network access points in the Washington, D.C. metropolitan area. Our west
coast data center is situated near the western network access points and the
headquarters of many of our strategic technology providers. Our London
SmartCenter(SM) serves as our headquarters location in Europe. We recently
expanded our total data center capacity and will be expanding our presence with
data centers in Europe and Asia in 2001 through our facilities agreement with
WorldCom. We intend to expand into other international locations over the next
five years as appropriate to meet anticipated customer and market demand.
Our data centers combine the predictability and control of traditional
mainframe-based data centers with the network access and capacity required for
today's Internet-based computing. Our data centers are designed to provide
consistently high service levels while permitting customers to rapidly deploy
new and strategic applications without substantially increasing cost or
incurring risk.
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The physical infrastructure and security controls of our data centers have
been designed to support rigorous requirements for secure data storage and
processing. Specifically, our data centers offer the following major physical
benefits to our customers:
- state-of-the-art physical security;
- multi-redundant mechanics, utilities and environmental controls;
- high-performance multi-network connectivity; and
- fully-integrated customer work areas.
State-of-the-art physical security. Our data centers include multiple
separate computer rooms offering customers a high degree of containment and
isolation from accidents or disasters occurring within or outside of each data
center. Physical security has been implemented through tightly controlled
security zones requiring access card, personal identification number, and
biometric identification. Each data center has five security zones that require
separate access levels to gain entry. Our highest security zones include
computer rooms physically constructed as a building-within-a-building, with fire
suppression and other controls separate from the remainder of the data center.
Fencing above the ceiling and below the raised floor isolate each security zone.
Over 100 surveillance cameras record movement through the data centers and
security guards provide real-time roaming visibility. Our cooling towers are
surrounded by security fences and monitored by cameras. Our dual 20,000 gallon
diesel fuel tanks are buried underground.
Multi-redundant mechanics, utilities and environmental controls. Within
each data center, separate mechanical rooms exist adjacent to each computer
room. These mechanical rooms house all cooling and mechanical equipment,
eliminating the possible introduction of liquid into the computer rooms from
equipment leakage. We use redundant uninterruptible power supply systems and
redundant diesel generators, to ensure the power system is capable of
maintaining power to the data center in the event of any component failure.
Cooling and environmental controls for each data center are designed to monitor
and ensure proper temperature and humidity.
High-performance network connectivity. Our data centers provide
high-performance, reliable networking connectivity to multiple national Internet
backbone carriers for our customers. Telecommunications circuits enter the data
centers through multiple points from diverse service providers. Multiple points
of presence ensure continued operation of service without degradation in the
unlikely event of a cable cut or local carrier network outage.
Fully integrated customer work areas. Our data centers include separate,
private customer work areas. These work areas are isolated from the security
zones that house our servers, permitting customers to work on-site as necessary.
These work areas provide computing and personal resources, such as customer
breakrooms and wash areas.
ITEM 3. LEGAL PROCEEDINGS
On September 5, 2000, and thereafter, Intermedia, Digex, the directors of
Digex, and in some cases, WorldCom, were named as defendants in a total of
thirteen lawsuits in the Court of Chancery of the State of Delaware in and for
New Castle County. Of those thirteen lawsuits, eight were brought as class
actions on behalf of Digex public shareholders, three were brought as derivative
actions, purportedly on behalf of Digex, and two advanced both class action and
derivative claims. On October 17, 2000, the Court ordered that all thirteen
lawsuits be consolidated into a single combined derivative and class action.
In general, the complaints advanced substantially similar allegations that
the defendants breached their fiduciary duties to the class members by acting to
further their own interests at the expense of Digex public stockholders, by
engaging in self-dealing and by failing to act in good faith towards the Digex
public stockholders. The complaints claimed that such alleged wrongdoing caused
irreparable harm to such stockholders. In addition, four of the complaints
alleged that the Digex board members who are also directors or executive
officers of Intermedia conferred a substantial benefit on Intermedia at the
expense of the Digex public stockholders by voting to waive application of
Section 203 of the Delaware General Corporation Law to future transactions
between WorldCom and Digex. These complaints also alleged that WorldCom aided
and
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abetted the wrongdoing of Intermedia's directors and the Intermedia-affiliated
directors of Digex. The complaints sought injunctive relief and unspecified
damages.
On February 15, 2001, WorldCom, Intermedia and Digex announced a proposed
settlement of the consolidated class action suit. The proposed settlement would,
if approved by the Court, fully resolve all claims in the lawsuit and permit the
Intermedia -- WorldCom Merger to proceed. As part of the settlement, WorldCom
and Intermedia have amended the terms of their merger agreement.
The principal terms of the proposed settlement with respect to Digex are:
- WorldCom and Digex have agreed on a series of commercial
arrangements that will offer WorldCom's customers favorable access
to our portfolio of managed web and application hosting services.
- A sales channel agreement will cover sales by the WorldCom sales
force of the advanced Web hosting services offered by us with a
sales commitment from WorldCom to us of up to $500.0 million over a
three year period, subject to our satisfying performance-related
criteria;
- After the completion of the Intermedia -- WorldCom Merger, WorldCom
will provide us with funding for the performance of our 2001 and
2002 business plans as approved by the Digex and WorldCom boards of
directors;
- Managed Web hosting facilities for Digex will be built at several
WorldCom data centers in the United States and around the globe.
- A settlement fund of $165.0 million in WorldCom common stock, based
upon WorldCom stock's trading price for a period preceding the
Intermedia -- WorldCom Merger, will be created for our stockholders
(other than Intermedia) and plaintiffs' counsel fees. Net of
plaintiffs' counsel fees, one-half of the settlement fund will be
distributed to holders of Digex Class A common stock on September 1,
2000. The balance will be distributed to such holders as of a future
record date to be determined and expected to be on or about the date
of the Intermedia -- WorldCom Merger.
- A fund of up to $15.0 million in cash will be created by WorldCom to
cover expenses incurred by us and a special committee of independent
directors of the Digex Board of Directors, as well as administrative
expenses of the settlement; and
- The approval of the Intermedia -- WorldCom Merger under Section 203
of the Delaware General Corporation Law by the Digex Board of
Directors will no longer be subject to challenge and WorldCom will
not be subject to any restrictions under Section 203 on future
transactions with Digex.
On March 2, 2001, Digex, WorldCom, and Intermedia entered into a definitive
Stipulation of Settlement with all relevant parties to settle all claims related
to the consolidated class action and derivative action in accordance with the
terms agreed to in the February 15, 2001 memorandum of understanding. The Court
has entered an order directing that notice of the settlement be sent to members
of the class and has scheduled a settlement hearing to be held on April 6, 2001
in the Delaware Court of Chancery in Wilmington, Delaware. The final settlement
of the suit is subject to the satisfaction of certain conditions as well as
final court approval. Based on the memorandum of understanding and the
Stipulation of Settlement, Digex does not expect to have any future liability
from the outcome of this litigation.
Digex also does not believe that there are any other pending or threatened
legal proceedings that, if adversely determined, would have a material adverse
effect on Digex's results of operations, cash flows, or financial position.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our Class A Common Stock trades on The Nasdaq Stock Market under the symbol
"DIGX." As of December 31, 2000, based upon 42 holders of record and an estimate
of the number of individual participants represented by security position
listings, there are approximately 16,294 beneficial holders of our Class A
Common Stock. All of our outstanding Class B Common Stock is held by Intermedia
Financial Company. The approximate high and low closing prices for our Class A
Common Stock are as reported by The Nasdaq Stock Market.
CLOSING PRICE
-----------------
HIGH LOW
------- ------
1999
Third quarter (from July 29, 1999)........................ $ 33.25 $15.50
Fourth quarter............................................ 86.88 21.19
2000
First quarter............................................. $171.50 $56.06
Second quarter............................................ 111.00 35.25
Third quarter............................................. 94.00 46.88
Fourth quarter............................................ 58.44 21.19
DIVIDEND POLICY
We do not anticipate paying any dividends on any of our common stock in the
foreseeable future. Moreover, because we are subject to restrictions under the
Intermedia indentures, we are effectively prohibited from paying dividends. We
may also incur indebtedness in the future, which may prohibit or effectively
restrict the payment of dividends.
The Litigation Settlement provides for a settlement fund to be established
consisting of WorldCom common stock having a "stated value" of $165.0 million.
The "stated value" of the WorldCom stock to be placed in the fund will be
determined by taking the average trading price on the Nasdaq National Market for
ten trading days randomly selected by lot from the 20 consecutive trading days
ending on the third trading day immediately preceding the closing date of the
Intermedia -- WorldCom Merger. The WorldCom common stock placed in the fund,
less the amount awarded to plaintiffs' counsel for legal fees and expenses, will
be distributed on a per share basis to the holders of Digex Class A common stock
as follows: (i) 50% will be distributed to the record holders of Digex Class A
common stock as of the closing of business on September 1, 2000; and (ii) 50%
will be distributed to the record holders of Digex Class A common stock of a
record date to be established in the future that is expected to be on or about
the closing date of the Intermedia -- WorldCom Merger.
This allocation of the WorldCom stock is subject to approval by the
Delaware Chancery Court, and the parties to the litigation settlement have
agreed they will change this allocation in whatever manner is necessary to
obtain final court approval of the litigation settlement. In addition, because
of the formula for determining the value of the WorldCom stock to be placed in
the settlement fund, it is possible that the "stated value" produced by such
formula may be higher or lower than the actual trading prices of the WorldCom
common stock on the date of deposit into the settlement fund or the distribution
of such stock to Digex Class A common stock holders.
Recent Sales of Unregistered Securities.
On January 12, 2000, Digex issued 50,000 shares of Series A Preferred Stock
and warrants to purchase 532,500 shares of Class A Common Stock, with an
exercise price of $57.00 per share, to Microsoft Corporation for an aggregate
consideration of $50.0 million. On January 12, 2000, Digex also issued 50,000
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shares of Series A Preferred Stock and warrants to purchase 532,500 shares of
Class A Common Stock, with an exercise price of $57.00 per share, to CPQ
Holdings, Inc., a subsidiary of Compaq Computer Corporation, for an aggregate
consideration of $50.0 million of which $35.0 million was paid in cash and $15.0
million was paid in the form of equipment credits granted to Digex. The 100,000
shares of Series A Preferred Stock are convertible into an aggregate of
approximately 1,462,000 shares of Class A Common Stock. Based on representations
by the purchasers, the issuances were made in reliance on the exemption from
registration provided by Section 4(2) of the Securities Act, as a transaction by
an issuer not involving a public offering.
Use of Proceeds from a Sale of Registered Securities
On July 29, 1999, the Registration Statement relating to our initial public
offering (SEC File No. 333-77105) was declared effective. The net proceeds of
the offering were approximately $178.9 million.
Under the terms of Intermedia's indentures, described under "Risk
Factors -- Digex is controlled by a controlling stockholder, which could involve
multiple risks for you as a stockholder," we were required to use all of the net
proceeds of our offerings to purchase telecommunications related assets.
Telecommunications-related assets mean assets used in connection with the
business of: (1) transmitting, or providing services relating to the
transmission of, voice, video or data through owned or leased transmission
facilities; (2) creating, developing and marketing communications related
network equipment, software and other devices for use relating to (1); or (3)
evaluating, participating in or pursuing any other activity or opportunity that
is related to those identified in (1) or (2); all as determined in good faith by
the board of directors of Intermedia. We have entered into a letter agreement
with Intermedia pursuant to which Intermedia will purchase from us, at our cost,
some of the Telecommunications Related Assets purchased with the net proceeds of
our offerings. Intermedia paid us for these Telecommunications Related Assets to
the extent necessary with funds not subject to restrictions under the Intermedia
indentures that we used for working capital purposes and to fund operating
losses.
From July 29, 1999 through the period ended June 30, 2000, we used $133.2
million of the net proceeds of our initial public offering to purchase
telecommunications related assets held by us and $45.7 million for the purchase
of telecommunications related assets subsequently sold to Intermedia. The
proceeds of the sales of assets to Intermedia were unrestricted and were used to
fund our operating expenses. All proceeds of our initial public offering have
been used as of June 30, 2000.
ITEM 6. SELECTED FINANCIAL AND OTHER OPERATING DATA
The following table sets forth selected historical financial data of Digex
for the period from July 7, 1997, the date of acquisition by Intermedia of the
Web site hosting unit (the "Predecessor"), to December 31, 1997, and the years
ended December 31, 1998, 1999 and 2000 of the Predecessor for the year ended
December 31, 1996 and the period from January 1, 1997 to July 6, 1997. The
selected historical financial data has been derived from Digex's and the
Predecessor's audited financial statements.
The following table also sets forth pro forma financial information of
Digex for the year ended December 31, 1997. The pro forma financial information
gives effect to the purchase by Intermedia of the Predecessor as if such
acquisition had occurred on January 1, 1997. The presentation of pro forma
financial information was made to permit useful comparison of results of
operations between periods presented. This pro forma financial information is
not necessarily indicative of the operating results Digex would have achieved if
the Predecessor had been acquired on January 1, 1997. The relationship between
Business Internet and the Predecessor is more fully described in Note 1 to the
consolidated financial statements.
In the following table, basic and diluted net loss per share have been
calculated assuming that the common shares issued in connection with our
recapitalization in April 1999 were outstanding for all periods of Digex
presented, and giving effect to the 50,000-for-one stock split of our Class B
Common Stock effected in July 1999 prior to the closing of our initial public
offering.
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The following financial information should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," "Business" and our consolidated financial statements and related
notes, included elsewhere in this report.
PREDECESSOR DIGEX
------------------------- -------------------------------------------------------------------------
HISTORICAL HISTORICAL PRO FORMA(1) HISTORICAL
------------------------- --------------- ------------- ---------------------------------------
PERIOD PERIOD FROM
FROM JULY 7, 1997
JANUARY 1, (DATE OF YEAR ENDED
YEAR ENDED 1997 ACQUISITION) TO YEAR ENDED DECEMBER 31,
DECEMBER 31, TO JULY 6, DECEMBER 31, DECEMBER 31, ---------------------------------------
1996 1997 1997 1997 1998 1999 2000
------------ ---------- --------------- ------------- ----------- ----------- -----------
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
STATEMENT OF OPERATIONS
DATA:
Revenues.................. $ 2,803 $ 4,420 $ 7,192 $ 11,612 $ 22,635 $ 59,786 $ 168,085
Costs and expenses:
Cost of operations...... 2,002 4,149 1,739 2,808 6,710 9,656 21,244
Cost of services........ 684 1,817 1,611 3,428 7,044 21,750 69,658
Selling, general and
administrative........ 3,194 7,001 6,087 13,088 17,512 70,213 144,876
Deferred compensation... -- -- -- -- -- 1,299 4,101
Depreciation and
amortization.......... 591 519 2,753 4,850 8,109 29,070 78,819
Charge off of purchased
in-process research
and development....... -- -- 15,000(2) 15,000(2) -- -- --
------------ ---------- --------------- ------------- ----------- ----------- -----------
Total costs and
expenses................ 6,471 13,486 27,190 39,174 39,375 131,988 318,698
------------ ---------- --------------- ------------- ----------- ----------- -----------
Loss from operations...... (3,668) (9,066) (19,998) (27,562) (16,740) (72,202) (150,613)
Other income (expense):
Interest expense........ -- -- -- -- -- (1,094) (2,008)
Interest and other
income................ -- -- -- -- -- 3,458 12,608
Merger-related
expenses.............. -- -- -- -- -- -- (2,922)
------------ ---------- --------------- ------------- ----------- ----------- -----------
Loss before income tax
benefit................. (3,668) (9,066) (19,998) (27,562) (16,740) (69,838) (142,935)
Income tax benefit........ -- -- 1,440 4,710 159 4,839 --
------------ ---------- --------------- ------------- ----------- ----------- -----------
Loss before cumulative
effect of change in
accounting principle.... (3,668) (9,066) (18,558) (22,852) (16,581) (64,999) (142,935)
Cumulative effect of
change in accounting
principle............... -- -- -- -- -- -- (166)
------------ ---------- --------------- ------------- ----------- ----------- -----------
Net loss.................. $ (3,668) $ (9,066) $ (18,558) $ (22,852) $ (16,581) $ (64,999) $ (143,101)
============ ========== =============== ============= =========== =========== ===========
PROFORMA AMOUNTS, ASSUMING
THE ACCOUNTING CHANGE IS
APPLIED RETROACTIVELY:
Net loss.................. $ (3,668) $ (9,066) $ (18,558) $ (22,852) $ (16,618) $ (65,115) $ (142,935)
============ ========== =============== ============= =========== =========== ===========
Net loss per common share:
basic and diluted....... -- -- $ (0.37) $ (0.46) $ (0.33) $ (1.19) $ (2.25)
============ ========== =============== ============= =========== =========== ===========
Shares used in computing
basic and diluted net
loss per share and
proforma net loss per
share................... -- -- 50,000,000 50,000,000 50,000,000 54,726,027 63,404,839
============ ========== =============== ============= =========== =========== ===========
OTHER DATA:
EBITDA before certain
charges(3).............. $ (3,077) $ (8,547) $ (2,245) $ (7,712) $ (8,631) $ (41,833) $ (67,693)
Net cash used in operating
activities.............. (2,565) (7,172) (6,079) (13,251) (10,930) (20,515) (62,520)
Net cash used in investing
activities.............. (1,445) (1,004) (55,237) (56,241) (30,969) (170,193) (204,604)
Net cash provided by
financing activities.... 4,010 8,176 61,316 69,492 41,899 279,486 261,818
Capital expenditures...... 1,445 1,004 8,016 9,020 30,969 170,396 202,604
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DIGEX
PREDECESSOR ------------------------------------------
------------ DECEMBER 31,
DECEMBER 31, ------------------------------------------
1996 1997 1998 1999 2000
------------ ------- ------- -------- --------
(IN THOUSANDS)
BALANCE SHEET DATA:
Cash and cash equivalents(4)........ $ -- $ -- $ -- $ 88,778 $ 83,434
Restricted investment............... -- -- -- -- 2,000
Working capital (deficit)........... (1,237) (351) 1,231 74,778 71,922
Property and equipment, net......... 2,599 12,930 39,059 205,903 348,975
Total assets........................ 3,173 49,693 77,739 344,309 521,051
Long-term note payable, including
current portion................... -- -- -- 3,712 4,207
Capital lease obligations, including
current portion................... 1,745 1,980 2,089 16,567 29,002
Total stockholders'/owner's
equity............................ $ 342 $45,527 $70,845 $290,189 $416,628
- ---------------
(1) The pro forma statement of operations data for the year ended December 31,
1997, represents the combining of the historical Predecessor statement of
operations data for the period from January 1, 1997 to July 6, 1997 and the
historical Digex statement of operations data for the period from July 7,
1997 to December 31, 1997, as adjusted for the following items:
- A decrease in cost of operations of $3,080 which represents reduced
network expenses.
- An increase in depreciation and amortization of $1,578 which
represents amortization of intangible assets arising from the
acquisition.
- An increase in income tax benefit of $3,270 which represents the
income tax effect of purchase accounting adjustments.
(2) This amount represents a one-time charge to operations for charge off of
purchased in-process research and development related to the Predecessor in
connection with Intermedia's purchase of Business Internet on July 7, 1997.
(3) EBITDA before certain charges consists of (earnings) loss before interest
expense, interest and other income, merger-related expenses, foreign
exchange gains (losses), income tax benefit, deferred compensation, charge
off of purchased in-process research and development, and depreciation and
amortization. EBITDA before certain charges does not represent funds
available for management's discretionary use and is not intended to
represent cash flow from operations. EBITDA before certain charges should
also not be construed as a substitute for operating income or a better
measure of liquidity than cash flow from operating activities, which are
determined in accordance with generally accepted accounting principles. This
caption excludes components that are significant in understanding and
assessing our results of operations and cash flows. In addition, EBITDA
before certain charges is not a term defined by generally accepted
accounting principles and as a result our measure of EBITDA before certain
charges might not be comparable to similarly titled measures used by other
companies. However, we believe that EBITDA before certain charges is
relevant and useful information which is often reported and widely used by
analysts, investors and other interested parties in the Web and application
hosting industry. Accordingly, we are disclosing this information to permit
a more comprehensive analysis of our operating performance, as an additional
meaningful measure of performance and liquidity, and to provide additional
information with respect to our ability to meet future debt service, capital
expenditure and working capital requirements.
(4) Prior to our initial public offering in July 1999, we participated in
Intermedia's and the Predecessor's centralized cash management system, and,
as a result, did not carry cash balances on our financial statements for any
period prior to the initial public offering. Since that date, we have
maintained and reported cash balances on our financial statements.
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
We are a leading provider of managed Web and application hosting services
to businesses operating mission-critical, multi-functional Web sites. We provide
the computer hardware, software, network technology, and systems management
necessary to provide our customers comprehensive, managed Web hosting and
application hosting solutions. We also offer related value-added services such
as firewall management, stress testing and consulting services, including
capacity and migration planning and database optimization. We currently provide
such services to a diversified customer base consisting of over 600 customers.
As of December 31, 2000, we managed approximately 4,216 Windows- and UNIX-based
servers in our state-of-the-art data centers which are strategically positioned
on the east and west coasts of the United States and in Europe.
Our revenues grew at a compounded annual growth rate of 178% between 1996
and 2000, from $2.8 million in 1996 to $168.1 million in 2000. We believe our
singular focus on delivering mission-critical Web site and application hosting
solutions has been the major contributor to our growth.
In January 2000, Microsoft and a subsidiary of Compaq invested $100.0
million in Digex, of which $85.0 million was paid in cash and $15.0 million was
paid in the form of equipment credits from Compaq. We also entered into
strategic development agreements with both companies to advance our capabilities
to more rapidly install, manage and upgrade large numbers of Microsoft
Windows-based servers and to streamline the order, delivery and installation of
Compaq hardware and storage devices.
On February 16, 2000, we completed a public offering of 12,650,000 shares
of our Class A Common Stock. We sold 2,000,000 shares of Class A Common Stock
and received net proceeds of approximately $171.6 million. Intermedia sold
10,650,000 shares of Class B Common Stock. The Class B Common Stock sold by
Intermedia automatically converted into Class A Common Stock at the closing of
the offering.
In May 2000, we created European operating entities to support our
international operations and opened our first data center outside of the United
States. Located in London, our European SmartCenter(SM) gives Digex customers in
Europe the superior level of technology, security, and support services in
Europe they have come to rely on in the United States. The data center is a
leased facility which became operational in July 2000.
We recently completed two rigorous assessments of our operating
environment. These assessments included a Type II review based on the American
Institute of Certified Public Accountants (AICPA)'s Statement on Auditing
Standards No. 70 (SAS70), and the Ernst & Young Cyber Process Certification.
These reviews examined Digex's managed data center facilities in three locations
in the United States and the United Kingdom. SAS70 was established by the AICPA
to provide a basis for examinations of the internal controls of service
organizations related to financial transaction processing. Digex had
successfully completed a SAS70 Type I review in May 2000. The Type II
review -- which requires testing of controls by the auditing firm -- was
conducted by Ernst & Young for the period July 1, 2000 through December 31,
2000. Also, Ernst & Young's Cyber Process Certification evaluated and tested the
design and operational effectiveness of controls to achieve the objectives
specified in the report, related to Digex's Web hosting services. Both reviews
focused on the control environment which govern the company's; (1) physical
security, (2) electronic security measures, (3) customer server infrastructure,
implementation, and maintenance, (4) network services and problem management,
and (5) business continuity. In February 2001, we successfully completed the
Type II review and the Cyber Process Certification for the six month period July
1, 2000 to December 31, 2000.
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On June 1, 2000, we entered into an Asset Migration Agreement with
Intermedia. Under the terms of the agreement, we purchased certain assets,
including certain licensed third-party software, machinery, and equipment from
Intermedia at cost to provide independent managed firewall services. We paid a
purchase price of $4.5 million for net book value of these assets and services
on June 30, 2000, the closing date of the agreement. Under the Asset Migration
Agreement, we made equal monthly installments amounting to $0.9 million for
Intermedia's support and consultation for the six month period ended December
31, 2000. In connection with the purchase of firewall-related assets from
Intermedia, the Managed Firewall Services Agreement between Digex and Intermedia
was terminated.
On June 29, 2000, we entered into a ten-year lease commencing in September
2000 for our new corporate headquarters facility in Laurel, Maryland. The lease
agreement requires an initial security deposit of $2.0 million in the form of a
letter of credit. This letter of credit may be reduced at the commencement of
the seventh lease year to an amount equal to the then current one month's base
rent if certain conditions are met annually prior to the seventh year of the
lease.
On September 1, 2000, Intermedia entered into a merger agreement with
WorldCom. During the third quarter, we have incurred legal fees, investment
advisory fees, accounting fees, and certain travel expenses associated with due
diligence activities relating to the merger and the possible sale of Digex.
Merger-related costs of $2.9 million were expensed as incurred during the year
ended December 31, 2000.
In October 2000, we entered into a Prime/Subcontractor Agreement with
WorldCom whereby we have agreed to provide managed hosting services to WorldCom
customers in the United States and in all international locations we presently
serve or in the future for certain service fees. Under the terms of the
agreement, we will provide the computer hardware, software, network technology,
Internet connectivity and systems management necessary to offer WorldCom's
customers comprehensive outsourced Web site and application hosting solutions.
In November 2000, WorldCom announced the immediate U.S. availability of an
expanded global Web hosting product suite to include high-end managed hosting
services through arrangements with Digex. Through the arrangement, we will be
able to connect our Internet data centers in the U.S. to the WorldCom global IP
network that runs through North America, South America, Europe, Asia, and
Australia with over 2,500 points of presence. We will also utilize WorldCom's
sales force to enhance its global presence.
Revenue. Our revenues consist primarily of monthly fees from our managed
Web and application hosting services. Contracts for these services are typically
between one and three years in length. In addition to Web and application
hosting, we also offer enterprise services and consulting services and believe
that we will begin to derive increasing amounts of revenues from the sale of
these services in the future. Revenue earned from the sale of third party
equipment is also included.
Costs and Expenses. Costs and expenses include:
- cost of operations;
- cost of services;
- selling, general and administrative expenses;
- deferred compensation; and
- depreciation and amortization expense.
Cost of operations consist primarily of the costs for our network
connectivity and firewall services. We expect our network connectivity
requirements to grow in conjunction with the growth of our overall business,
including the expansion of our business abroad through our wholly-owned
subsidiaries, and accordingly expect these costs to increase in the future.
Expenses directly attributed to the sale of third party equipment is also
included.
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Cost of services consist primarily of facilities administration expenses
including rent, maintenance and utilities to support our data centers and
salaries and related benefits for our technical operations. We expect our cost
of services to increase in dollar amount but to decline as a percentage of
revenue due to economies of scale and expected improvements in technology and
productivity.
Selling, general and administrative expenses consist primarily of salaries
and benefits for our marketing, sales and support personnel, advertising costs,
consultants' fees, provision for doubtful accounts and other miscellaneous
expenses. We expect selling, general and administrative expenses to increase in
dollar amount and to decline as a percentage of revenue over time.
Deferred compensation expense relates to stock options that were granted by
Digex to certain employees at exercise prices below market value.
Depreciation and amortization expense consists primarily of depreciation of
our data centers, servers and related equipment and amortization of our
intangible assets. We expect these expenses to increase due to our plans to
invest significant capital to continue to expand our data center capacity.
PLAN OF OPERATION
We plan to expand our Web and application hosting business by focusing on
large companies which are looking to develop a presence on the Internet by both
providing e-commerce business solutions to their customers and outsourcing the
management of their Web sites and Web-enabled business applications. In the
fourth quarter of 1999, we opened our state-of-the-art data centers on the east
and west coasts of the United States. Our first international data center,
located in London, was operational in July 2000. We anticipate that these data
centers, when operating at full capacity, will support servers generating in
excess of $800.0 million in annualized revenue. We believe that the new data
centers in the United States and those we continue to develop internationally
will place us in a stronger competitive position to successfully provide
outsourced solutions of scalable managed Web and application hosting solutions.
We also offer value-added services, such as firewall management, stress testing,
and consulting services, including capacity and migration planning and database
optimization, and believe that we will derive increasing amounts of revenue from
these services in the future.
Our commercial agreements with WorldCom will allow us to purchase bandwidth
and connectivity from WorldCom in the United States and around the globe to
support our managed Web hosting activities. Through the arrangements, we will be
able to connect our Internet data centers in the U.S. to the WorldCom global IP
network that runs through North America, South America, Europe, Asia, and
Australia with over 2,500 points of presence.
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RESULTS OF OPERATIONS
The following table presents certain information derived from our audited
financial statements for the years ended December 31, 2000, 1999, and 1998
expressed as a percentage of revenue.
YEAR ENDED DECEMBER 31,
------------------------
2000 1999 1998
----- ------ -----
Revenues........................................... 100.0% 100.0% 100.0%
Costs and expenses:
Cost of operations............................... 12.6 16.2 29.6
Cost of services................................. 41.4 36.4 31.1
Selling, general and administrative.............. 86.2 117.4 77.5
Deferred compensation............................ 2.4 2.2 --
Depreciation and amortization.................... 46.9 48.6 35.8
----- ------ -----
Total costs and expenses................. 189.6 220.8 174.0
----- ------ -----
Loss from operations............................... (89.6) (120.8) (74.0)
Other income (expense):
Interest expense................................. (1.2) (1.8) --
Interest and other income........................ 7.5 5.8 --
Merger-related expense........................... (1.7) -- --
----- ------ -----
Loss before income tax benefit..................... (85.0) (116.8) (74.0)
Income tax benefit................................. -- 8.1 .7
----- ------ -----
Loss before cumulative effect of change in
accounting principle............................. (85.0)% (108.7)% (73.3)%
===== ====== =====
YEAR ENDED DECEMBER 31, 2000 COMPARED TO THE YEAR ENDED DECEMBER 31, 1999
Revenue
Total revenue increased 181.1% to $168.1 million in 2000 compared to $59.8
million in 1999. The increase in revenue was due to customer growth of 12% from
December 31, 1999 to December 31, 2000, a significant increase in the number of
managed servers per customer, and a rise of average monthly revenue per server
in the fourth quarter of $4,259 in 2000 compared to $3,354 for the same period
in 1999. Our installed base of servers increased 82% to 4,216 at December 31,
2000 from 2,311 at December 31, 1999. In addition to revenue from managed Web
and application hosting services, Digex recognized $5.0 million of third party
equipment sales revenue in the second quarter of 2000.
Cost of Operations
Cost of operations increased 120.0% to $21.2 million in 2000 compared to
$9.6 million in 1999. The increase was due to additional network costs resulting
from our expanded customer base and increases in service offerings. As a
percentage of revenue excluding second quarter equipment sales, cost of
operations excluding the second quarter cost of third party equipment decreased
to 10.7% in 2000 compared to 16.2% in 1999 due to the net effect of improved
network utilization.
Cost of Services
Cost of services increased 220.3% to $69.7 million in 2000 compared to
$21.7 million in 1999. The increase was primarily related to the increased level
of operations and the expansion of our new data centers including costs related
to the hiring of additional personnel and consultants in customer service,
engineering, and facilities administration supporting server growth. As a
percentage of revenue, total cost of services increased to 41.4% in 2000
compared to 36.4% in 1999. Costs did not increase proportionally with revenue
due primarily to additional costs incurred in 2000 related to the asset
migration agreement.
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Selling, General and Administrative
Selling, general and administrative expenses increased 106.3% to $144.9
million in 2000 compared to $70.2 million in 1999. Through 2000, as part of our
growth strategy, we continued to build our infrastructure and administrative
requirements to operate as a separate public company. Increases in selling,
general and administrative expenses for 2000 included the costs associated with
an increased employee base, advertising campaigns, back office support
(including the G&A Agreement, as amended, with Intermedia), rent for additional
office space, consultants' professional fees, an increased provision for
doubtful accounts receivable and the addition of key executive management to
support the growth of the business. We expect that our growth strategy will
continue to require significant sales and marketing activities, including an
expansion of our sales force and further development of brand name recognition.
In addition, we will continue to build our personnel base to support our growth
strategy in the managed Web and application hosting industry. As a result, we
believe that our selling, general and administrative expenses will continue to
increase in the future. As a percentage of revenue, total selling, general and
administrative expenses decreased to 86.2% in 2000 compared to 117.4% in 1999
due primarily to revenue growth and because the selling portion of the selling,
general and administrative cost is fixed, expenses will not increase
proportionally according to revenue.
Deferred Compensation
Deferred compensation expense increased 215.7% to $4.1 million in 2000
compared to $1.3 million in 1999. The increase was primarily due to increases in
stock options granted to certain employees at exercise prices below market value
since July 29, 1999. We recorded approximately $13.5 million of deferred
compensation in 1999 and $2.1 million (net of forfeitures) in 2000, a separate
component of stockholders' equity, to be expensed over the four-year vesting
period of the options.
Depreciation and Amortization
Depreciation and amortization expenses increased 171.1% to $78.8 million in
2000 compared to $29.0 million in 1999. The increase was principally due to
additional servers and other facilities and equipment placed in service since
December 31, 1999. We entered into a capital lease for our corporate
headquarters facility in the third quarter of 2000, which also contributed to
the increase in expense. We have electronics, computer hardware, and computer
software with useful lives ranging from three to five years. We expect increases
in depreciation charges though 2001 due to the continued expansion of our new
data centers and due to future increased server installations based on customer
demand.
Interest Expense
Interest expense increased 83.5% to $2.0 million in 2000 compared to $1.1
million in 1999. The increase resulted from the capital leases assigned to us by
Intermedia during the second quarter of 1999 and the capital lease for our new
corporate headquarters facility in the third quarter of 2000. Additionally, a
note payable was issued by us to a third party during the third quarter of 1999.
Interest and Other Income
Interest and other income increased 264.6% to $12.6 million in 2000
compared to $3.5 million in 1999. The increase resulted principally from
interest earned on the cash proceeds from the investment in Digex by Microsoft
and a subsidiary of Compaq, an initial and subsequent public equity offering,
and exercised stock options.
Merger-related Expenses
Merger-related expenses of $2.9 million associated with due diligence
activities relating to the merger and the possible sale of Digex were incurred
in 2000.
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EBITDA Before Certain Charges
EBITDA before certain charges, as defined below, increased 61.8% to $(67.7)
million in 2000 compared to $(41.8) million in 1999. The change is primarily
attributable to costs associated with our growth strategy. Costs associated with
the administration and maintenance of our expanded data centers and increased
selling, general and administrative costs will continue to represent a large
portion of expenses during our planned expansion. In addition, we expect to
continue to experience growth in marketing and selling expenses as new customers
are acquired.
EBITDA before certain charges consists of earnings (loss) before interest
expense, interest and other income, merger-related expenses, foreign exchange
gains (losses), income tax benefit, deferred compensation, and depreciation and
amortization. EBITDA before certain charges does not represent funds available
for management's discretionary use and is not intended to represent cash flow
from operations. EBITDA before certain charges should also not be construed as a
substitute for operating income or a better measure of liquidity than cash flow
from operating activities, which are determined in accordance with generally
accepted accounting principles. This caption excludes components that are
significant in understanding and assessing our results of operations and cash
flows. In addition, EBITDA before certain charges is not a term defined by
generally accepted accounting principles and as a result our measure of EBITDA
before certain charges might not be comparable to similarly titled measures used
by other companies. However, we believe that EBITDA before certain charges is
relevant and useful information which is often reported and widely used by
analysts, investors and other interested parties in the Web and application
hosting industry. Accordingly, we are disclosing this information to permit a
more comprehensive analysis of our operating performance, as an additional
meaningful measure of performance and liquidity, and to provide additional
information with respect to our ability to meet future debt service, capital
expenditure and working capital requirements. See the consolidated financial
statements and notes thereto contained elsewhere in this report for more
detailed information.
YEAR ENDED DECEMBER 31, 1999 COMPARED TO THE YEAR ENDED DECEMBER 31, 1998
Revenue
Total revenue increased 164.6% to $59.8 million in 1999 compared to $22.6
million in 1998. The increase in revenue was due primarily to new customer
growth and to an increase in the number of servers per customer and revenue per
server. Our installed base of servers increased 120.5% from 1,048 at December
31, 1998 to 2,311 at December 31, 1999.
Cost of Operations
Cost of operations increased 43.3% to $9.6 million in 1999 compared to $6.7
million in 1998. The increase was primarily due to additional network costs
resulting from our expanded customer base and increase in service offerings
since December 31, 1998. In addition, there were more servers on line since
December 31, 1998. As a percentage of revenue, cost of operations decreased to
16.2% in 1999 compared to 29.6% in 1998 as a result of improved network
utilization associated with the revenue improvement discussed above.
Cost of Services
Cost of services increased 210.0% to $21.7 million in 1999 compared to $7.0
million in 1998. The increase was due primarily to increased facilities and
engineering costs to support our growth and to support the expansion of our data
centers. As a percentage of revenue, cost of services increased to 36.4% in 1999
compared to 31.1% in 1998.
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Selling, General and Administrative
Selling, general and administrative expenses increased 301.1% to $70.2
million in 1999 compared to $17.5 million in 1998. As a percentage of revenue,
total selling, general and administrative expenses increased to 117.4% in 1999
compared to 77.5% in 1998 due primarily to the significant administrative
requirements to support our growth strategy. During 1998, the managed Web site
and application hosting business operated as part of a wholly owned subsidiary
of Intermedia. During 1999, as part of our growth strategy, we continued
building up our infrastructure to operate as a separate public company.
Increases in selling, general and administrative expenses for 1999 include the
costs associated with an increased employee base, advertising campaigns, back
office support (including the General and Administrative Services Agreement with
Intermedia), an increased provision for doubtful accounts receivable, and the
addition of key executive management to support the growth of the business. We
expect that our growth strategy will continue to require significant sales and
marketing activities, including an expansion of our sales force and further
development of brand name recognition. In addition, we will continue to build
our personnel base to support our growth strategy in the managed Web site and
application hosting industry. As a result, we believe that our selling, general
and administrative expenses will continue to increase in the future.
Deferred Compensation
During 1999, we granted stock options to certain employees at exercise
prices below market value. As a result, we recorded approximately $12.2 million
and $1.3 million of deferred compensation in the third and fourth quarter of
1999, respectively, to be expensed over the four-year vesting period of the
options.
Depreciation and Amortization
Depreciation and amortization expenses increased 258.0% to $29.0 million in
1999 compared to $8.1 million in 1998. The increase was principally due to
additional servers and other facilities and equipment placed in service since
December 31, 1998. We expect increases in depreciation charges next year due to
the continued expansion of our data centers and due to future increased server
installations.
Interest Expense
Interest expense of $1.1 million in 1999 resulted from the capital leases
assigned to us by Intermedia during the second quarter of 1999 and a note
payable issued by us during the third quarter of 1999.
Interest and Other Income
Interest and other income of $3.5 million resulted principally from
interest earned on the cash proceeds from the initial public offering completed
in August 1999.
Loss Before Income Tax Benefit
Net loss before income tax benefit increased 318.0% to $(69.8) million in
1999 compared to $(16.7) million in 1998. As more fully discussed above, the
increased loss is attributable to growth strategy costs in excess of current
period revenues.
Income Tax Benefit
In connection with Intermedia's contribution of assets on April 30, 1999,
we recorded a deferred tax liability, net of deferred tax assets, of $4.8
million. The deferred tax liability was related to certain identifiable
intangible assets. Since the date of the contribution, we experienced taxable
losses and non-deductible expenses that resulted in recognition of deferred tax
assets in excess of the deferred tax liability. Accordingly, we recorded a $4.8
million deferred tax benefit during the second quarter of 1999.
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EBITDA Before Certain Charges
EBITDA before certain charges, as defined below, increased 386.0% to
$(41.8) million in 1999 compared to $(8.6) million in 1998. The change is
primarily attributable to costs associated with our growth strategy. Costs
associated with the administration and maintenance of our expanded data centers
and increased selling, general and administrative costs will continue to
represent a large portion of our expenses during our planned expansion. In
addition, we expect to continue to experience rapid growth in marketing and
selling expenses as new customers are acquired.
EBITDA before certain charges consists of earnings (loss) before interest
expense, interest and other income, income tax benefit, deferred compensation,
depreciation and amortization, and the charge off of purchased in-process
research and development. EBITDA before certain charges does not represent funds
available for management's discretionary use and is not intended to represent
cash flow from operations. EBITDA before certain charges should also not be
construed as a substitute for operating income or a better measure of liquidity
than cash flow from operating activities, which are determined in accordance
with generally accepted accounting principles. This caption excludes components
that are significant in understanding and assessing our results of operations
and cash flows. In addition, EBITDA before certain charges is not a term defined
by generally accepted accounting principles and as a result our measure of
EBITDA before certain charges might not be comparable to similarly titled
measures used by other companies. However, we believe that EBITDA before certain
charges is relevant and useful information which is often reported and widely
used by analysts, investors and other interested parties in the Web site and
application hosting industry. Accordingly, we are disclosing this information to
permit a more comprehensive analysis of our operating performance, as an
additional meaningful measure of performance and liquidity, and to provide
additional information with respect to our ability to meet future debt service,
capital expenditure and working capital requirements. See the financial
statements and notes thereto contained elsewhere in this report for more
detailed information.
LIQUIDITY AND CAPITAL RESOURCES
We have used cash in our operating and investing activities during all
periods since inception. These cash usages have been funded by permanent
contributions to capital from Intermedia. Such contributions amounted to $148.3
million in 1999 and $41.9 million in 1998. Since the date of our initial public
offering, there have been no permanent capital contributions made by Intermedia.
Net cash used in operating activities was $62.5 million in 2000, $20.5
million in 1999, and $10.9 million in 1998. Net cash used for operating
activities in each of these periods was primarily the result of operating losses
and changes in working capital.
Net cash used for investing activities was $204.6 million in 2000, $170.2
million in 1999, and $31.0 million in 1998. Net cash used for investing
activities in each of these periods was primarily the result of capital
expenditures for data center infrastructure which includes servers purchased for
customer use, as well as leasehold improvements, furniture and fixtures and
computers and other equipment, including a $2.0 million letter of credit
pursuant to a ten-year lease entered into by us on June 29, 2000 for our new
corporate headquarters facility in Laurel, Maryland. Although we have plans to
invest significantly in property and equipment, we have no material commitments
for such items at this time.
Prior to the date of our initial public offering, our capital expenditures
and operating expenses were principally funded by Intermedia. On August 4, 1999,
we sold 11,500,000 shares of Class A Common Stock in our initial public
offering. The net proceeds from the offering were approximately $178.9 million.
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On January 12, 2000, we sold 100,000 shares of our Series A Preferred Stock
and Warrants to purchase 1,065,000 shares of Class A Common Stock to Microsoft
and a subsidiary of Compaq for aggregate gross proceeds of $100.0 million, of
which $85.0 million was paid in cash and $15.0 million was paid in the form of
equipment credits from Compaq. The Preferred Stock has an aggregate liquidation
preference of $100.0 million and is convertible into approximately 1,462,000
shares of Class A Common Stock. The Warrants can be exercised at any time over
their three-year term at a price of $57.00 per share (the fair value of our
Class A Common Stock on the transaction commitment date).
To the extent necessary to perform our obligations under our agreement with
Compaq, the proceeds from the investment by a subsidiary of Compaq will be used
toward the development of a platform for the delivery of high-performance
application hosting services, which will include capital expenditures and
research and development expenditures. Therefore, we do not expect the proceeds
of the investment by a subsidiary of Compaq to be available for general
corporate purposes. We also intend to use the proceeds of the investment by
Microsoft to fund this development project.
On February 16, 2000, we completed a public offering of 12,650,000 shares
of our Class A Common Stock. We sold 2,000,000 shares of Class A Common Stock
and received net proceeds of approximately $171.6 million. Intermedia sold
10,650,000 shares of Class B Common Stock. The Class B Common Stock sold by
Intermedia automatically converted into Class A Common Stock at the closing of
the offering.
The net proceeds of our public offerings and the cash proceeds of the
investments by Microsoft and Compaq were used to purchase telecommunications
related assets due to restrictions in Intermedia's debt instruments. Therefore,
to provide for the funding of our operating expenses, we made arrangements with
Intermedia to sell to Intermedia certain telecommunications related assets that
were purchased by Digex with the net proceeds of these offerings. The assets
were sold to Intermedia for cash at our cost. We received approximately $33.7
million in 2000 and $25.3 million in 1999 from Intermedia related to the sale of
telecommunications related assets. These proceeds were unrestricted and were
used to fund our operating expenses. See "Market for Registrant's Common Equity
and Related Stockholder Matters -- Use of Proceeds from a Sale of Registered
Securities."
In June 2000, the Department of Business and Economic Development of
Maryland received approval from the Maryland General Assembly Legislative Policy
Committee to provide $3.0 million in funding to Digex for the development of a
Web hosting facility in Prince George's County, Maryland under the Sunny Day
Fund initiative. The funds will initially be provided to us in the form of a
conditional loan which will accrue deferred interest at 5%. If certain
conditions are met, the conditional loan and accrued interest will be forgiven.
The Committee also approved our eligibility to seek an additional $1.0 million
in such funding on or after January 1, 2005 if certain conditions are met. We
received the proceeds from the $3.0 million conditional loan in January 2001.
In accordance with the Digex Long-Term Incentive Plan, stock options
granted to certain employees of Digex and Intermedia became vested and
exercisable beginning in the second quarter of 2001. Cash proceeds of $6.1
million were received from exercised stock options during the year ended
December 31, 2000. We may continue to receive cash proceeds from stock options
in the future as an increasing number of options will become exercisable
according to each optionee's respective vesting schedule.
On September 1, 2000, Intermedia entered into a merger agreement with
WorldCom whereby, upon consummation of the merger, a subsidiary of WorldCom will
be merged with and into Intermedia and Intermedia will become a subsidiary of
WorldCom. As a result of the merger, WorldCom will beneficially own a majority
of our capital stock and will have voting control of us. The merger is expected
to be consummated in the second quarter of 2001. See "Business -- Recent
Developments."
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On October 31, 2000, Intermedia increased the commitments available to it
under its Revolving Credit Facility ("Credit Facility") from $100.0 million to
$350.0 million. The Credit Facility is fully guaranteed by WorldCom. As a
subsidiary of Intermedia, we are a limited guarantor under the Credit Facility
to the greater of $90.0 million or the amounts borrowed by Digex. Through
Intermedia, we expect to have access to the proceeds available under the Credit
Facility to fund a portion of our capital expenditures as liquidity needs arise
consistent with our projections. As of December 31, 2000, Intermedia had $113.0
million outstanding on its Credit Facility.
On October 31, 2000, Intermedia also entered into a Note Purchase Agreement
with WorldCom. Intermedia authorized the issue and sale of up to $225.0 million
aggregate principal amount of 14.12% Senior Subordinated Notes due 2009 and
22,500 shares of Series H Preferred Stock. Through Intermedia, we expect the
proceeds from these financings will be available to fund our operations, working
capital needs and capital expenditures as liquidity needs arise. Intermedia had
not made any borrowings under these financings as of December 31, 2000.
We expect to enter into a master lease and financing agreement with a
vendor for a line of credit of up to $25.0 million to facilitate the leasing of
computer hardware and software in the future. The initial term of the agreement
ranges from 24 to 36 months. We also have an option to purchase the equipment at
the end of the initial lease term.
After the anticipated closing of the Intermedia -- WorldCom Merger,
WorldCom has agreed that it will provide funding to us for the performance of
our 2001 and 2002 business plans as approved by the Digex and WorldCom boards of
directors. Such funding will bear interest at a rate equal to LIBOR plus 300
basis points and will be repayable over a four-year period commencing in 2003.
The terms of such funding are expected to contain conditions to borrowing,
covenants and other terms that have not yet been negotiated but could restrict
our access to the availability to such funds. In addition, any changes to our
business plans that requires increased funding would require the WorldCom board
of directors' approval before WorldCom would be obligated to fund any such
increase.
We expect to continue experiencing negative cash flow from operating and
investing activities due to our plans for expansion and the growth of our
business. We anticipate we will have significant cash requirements for several
years as we expand our data center capacity, increase servers under management,
increase our employee base, acquire additional office space to support our
expanding operations and invest in our marketing organization. In addition, we
expect to invest significantly in the purchase of property and equipment and for
research and development, including funding the expenses associated with our
research and development alliance with Microsoft and a subsidiary of Compaq. We
expect our capital expenditures to increase due to the growth of servers under
management and our continuing data center expansion in the United States and
abroad. With our existing cash resources and financing available from
Intermedia, we believe we have sufficient capital to sustain our current
operations and capital expenditure plans into mid 2001. Upon depletion of these
financing sources, we intend to rely on WorldCom for funding. There can be no
assurance that such funding will be available on terms satisfactory to us. In
the event the Intermedia -- WorldCom Merger does not close, our intention would
be to access the capital markets for our necessary funding. Management has had
preliminary discussions with third party sources regarding potential financing,
including vendor financing facilities or other asset backed secured financing.
Based on these discussions, management believes that we will have access to
capital markets to obtain sufficient funding to continue our business plans as
described above or, at a minimum, in an amount that would provide sufficient
funding to execute a modified or curtailed plan into 2002. See Risk
Factor -- "The failure of the Intermedia -- WorldCom Merger to close would
adversely impact us."
Intermedia is and will continue to be highly leveraged. At December 31,
2000 and 1999, Intermedia had outstanding approximately $2.8 billion and $3.2
billion of debt and other liabilities including trade payables, respectively,
and a total of approximately $1.1 million and $916.8 million of obligations with
respect to the outstanding series of preferred stock, respectively. In addition,
as of December 31, 2000, Intermedia borrowed $113.0 million under its $350.0
million credit facility. Intermedia has also entered into a $225.0 million Note
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Purchase Agreement with WorldCom. Through Intermedia, we expect the proceeds
from these financings will be available to fund our operations, working capital
needs and capital expenditures as liquidity needs arise.
Intermedia's level of debt will require it to dedicate a substantial
portion of its future cash flow from operations for payment of principal and
interest on its debt, as well as dividends on and the redemption of its
preferred stock. Historically, Intermedia has not generated sufficient cash flow
to cover its operating and investing expenses. For the years ended December 31,
2000 and 1999, Intermedia's earnings were insufficient to cover combined fixed
charges and dividends on preferred stock. The auditors of Intermedia have
expressed in their opinion that while Intermedia's consolidated financial
statements have been prepared assuming that it will continue as a going concern,
Intermedia has incurred recurring operating losses and has a net capital
deficiency, and as a result, these conditions raise substantial doubt about
Intermedia's ability to continue as a going concern.
INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
The information set forth above in "Management's Discussion and Analysis of
Financial Conditions and Results of Operations" includes forward-looking
statements that involve numerous risks and uncertainties within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended, including statements concerning the
future outcome of litigation and the completion of the Intermedia -- WorldCom
Merger. Forward-looking statements can be identified by the use of
forward-looking terminology such as "estimates," "projects," "anticipates,"
"expects," "intends," "believes," or the negative thereof or other variations
thereon or comparable terminology or by discussions of strategy that involve
risks and uncertainties. See "Risk Factors -- This report includes forward-
looking statements which could differ from actual results."
INCOME TAXES
We account for income taxes under SFAS No. 109, Accounting for Income
Taxes. At December 31, 2000, a full valuation allowance was provided on net
deferred tax assets of $75.2 million based upon our deficit in earnings and the
uncertainty surrounding our ability to recognize such assets. The valuation
allowance relates primarily to a net operating loss carryforward. Income tax
accounting information is disclosed in Note 8 to the Consolidated Financial
Statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We expect to continue recognizing revenue from international sales
denominated in foreign currency. As a global concern, we could face exposure to
adverse movements in foreign currency exchange rates on the financial results of
foreign subsidiaries that are translated into U.S. dollars upon consolidation.
These exposures may change over time as business practices evolve and could
affect our financial results. Currently, we do not hedge against any foreign
currency risk and, as a result, could incur gains or losses.
While our long-term note payable bears an effective fixed interest rate,
the fair market value of our fixed rate long-term note payable is sensitive to
changes in interest rates. We run the risk that market rates will decline, and
the required payments will exceed those based on current market rates. Under our
current risk management policies, we do not use interest rate derivative
instruments to manage our exposure to interest rate changes.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements listed in Item 14 are included in
this report beginning on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
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PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item 10 is incorporated by reference from
the information captioned "Proposal One: Election of Directors" and "Executive
Officers" to be included in the Company's proxy statement for its 2001 Annual
Meeting of Stockholders (the "Proxy Statement").
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item 11 is incorporated by reference from
the information captioned "Executive Compensation," "Compensation Committee
Interlocks and Insider Participation," and "Comparative Stock Performance" to be
included in the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item 12 is incorporated by reference from
the information captioned "Beneficial Ownership" to be included in the Proxy
Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by the Item 13 is incorporated by reference from
the information captioned "Certain Relationships and Related Transactions" to be
included in the Proxy Statement.
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PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Financial Statement and Financial Statement Schedules
The following consolidated financial statements of the Company and the
notes thereto, the related reports thereon of the independent auditors, and
financial statement schedules, are filed pursuant to Item 8 of this Report:
INDEX TO FINANCIAL STATEMENTS
PAGE
----
Report of Independent Auditors.............................. F-1
Consolidated Balance Sheets as of December 31, 2000 and
1999...................................................... F-2
Consolidated Statements of Operations for the Years Ended
December 31, 2000, 1999, and 1998......................... F-3
Consolidated Statements of Stockholders' Equity for the
Years Ended December 31, 2000, 1999, and 1998............. F-4
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2000, 1999, and 1998......................... F-5
Notes to Consolidated Financial Statements.................. F-6
FINANCIAL STATEMENT SCHEDULES
Schedule II -- Valuation and Qualifying Accounts............ F-24
All other financial statement schedules for which provision is made in the
applicable accounting regulations of the Securities and Exchange Commission (the
"SEC") are not required pursuant to the instructions to Item 8 or are
inapplicable and therefore have been omitted.
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EXHIBIT INDEX
All Exhibits listed below are filed with this Annual Report on Form 10-K
unless specifically stated to be incorporated by reference to other documents
previously filed with the SEC.
EXHIBIT
NUMBERS DESCRIPTION
- ------- -----------
2.1 -- Contribution Agreement by and between Digex and Business
Internet, Inc., dated as of April 30, 1999.*
2.2 -- Assignment and Assumption Agreement by and between Digex and
Business Internet, Inc., dated as of April 30, 1999.*
2.3 -- Trademark Assignment by and between Digex and Business
Internet, Inc., dated as of April 30, 1999.*
2.4 -- Bill of Sale to the Contribution Agreement, dated as of
April 30, 1999.*
2.5 -- Agreement and Plan of Merger among WorldCom, Inc., Wildcat
Acquisition Corp. and Intermedia Communications Inc., dated
as of September 1, 2000. Incorporated herein by reference to
Digex's Form 8-K (File No. 000-26873) filed with the SEC on
September 7, 2000.
3.1 -- Certificate of Incorporation of Digex, as amended.
Incorporated herein by reference to Digex's Form 10-Q (File
No. 000-26873) filed with the SEC on September 13, 1999.
3.2 -- Bylaws of Digex, as amended. Incorporated herein by
reference to Digex's Form 10-Q (File No. 000-26873) filed
with the SEC on May 12, 2000.
3.3 -- Certificate of Designation for the Series A Preferred
Stock.**
3.4 -- See the Certificate of Incorporation of Digex, as amended to
date, filed as Exhibit 3.1.
3.5 -- Proposed Amendment to the Certificate of Incorporation.
Incorporated herein by reference to Digex's Form 8-K (File
No. 000-26873) filed with the SEC on February 15, 2001.
4.1 -- Warrant Agreement, dated as of January 12, 2000, among
Digex, Microsoft Corporation and CPQ Holdings, Inc.**
4.2 -- Registration Rights Agreement, dated as of January 12, 2000,
among Digex, Microsoft Corporation and CPQ Holdings, Inc.**
10.1 -- Intentionally Omitted.
10.2 -- Lease by and between Intermedia and Intel Corporation, dated
as of November 10, 1998.*
10.3 -- Lease by and between Intermedia and Ammendale Commerce
Center Limited Partnership, dated as of April 15, 1998.*
10.4 -- Lease by and between Intermedia and 1111 19th Street
Associates, dated as of July 23, 1998.*
10.5 -- Contract for Construction by and between Intermedia and R.W.
Murray Company, d/b/a The Murray Company, dated as of
February 19, 1999.*
10.6 -- Contract for Construction by and between Intermedia and R.W.
Murray Company, d/b/a The Murray Company, dated as of
January 4, 1999.*
10.7 -- Software License and Services Agreement by and between Digex
and Oracle Corporation, dated as of May 27, 1999.*
10.8 -- License Agreement by and between Digex and Microsoft
Corporation.*
10.9 -- Consulting Letter Agreement by and between Digex, Intermedia
and Andersen Consulting LLP, dated as of April 1, 1999.*
10.10 -- Internet Transit Services Agreement (East Coast) between
Digex and Business Internet, Inc., dated as of April 30,
1999.(2)*
10.11 -- Internet Transit Services Agreement (West Coast) between
Digex and Business Internet, Inc., dated as of April 30,
1999.(2)*
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EXHIBIT
NUMBERS DESCRIPTION
- ------- -----------
10.12 -- Managed Firewall Services Agreement between Digex and
Business Internet, Inc., dated as of April 30, 1999.(2)*
10.13 -- Employment Letter dated June 29, 1999 between Digex and Mark
K. Shull, and amendments thereto.(1)**
10.14 -- Employment Letter dated December 14, 1998 between Digex and
Nancy G. Faigen, and amendments thereto.(1)**
10.15 -- Employment Letter dated July 9, 1999 between Digex and
Rebecca Ward, and amendments thereto.(1)**
10.16 -- Employment Letter dated July 9, 1999 between Digex and Bryan
T. Gernert, and amendments thereto.(1)**
10.17 -- Employment Letter dated December 15, 1999 between Digex and
Timothy M. Adams, and amendments thereto.(1)**
10.18 -- Employment Letter dated September 11, 1996 between Digex and
Robert B. Patrick, and amendments thereto.(1)**
10.19 -- Digex Long-Term Incentive Plan.(1)**
10.20 -- Intermedia 1996 Long-Term Incentive Plan.(1)**
10.21 -- General and Administrative Services Agreement between Digex
and Intermedia, dated as of April 30, 1999.*
10.22 -- Amendment No. 1, dated as of January 17, 2000, to General
and Administrative Services Agreement between Digex and
Intermedia.**
10.23 -- Use of Proceeds Agreement between Digex and Intermedia,
dated as of June 2, 1999.**
10.24 -- Use of Proceeds Agreement between Digex and Intermedia,
dated as of January 11, 2000.**
10.25 -- Use of Proceeds Agreement between Digex and Intermedia,
dated as of January 24, 2000.**
10.26 -- Expense Summary and Indemnity Arrangement Agreement between
Digex and Intermedia, dated as of January 24, 2000.**
10.27 -- Employment Letter dated March 22, 2000 between Digex and
Thomas Davidsson.(1)***
10.28 -- Employment Letter dated July 5, 2000 between Digex and Todd
Carlson, and amendments thereto.(2)***
10.29 -- Employment Letter dated July 6, 2000 between Digex and Bruce
F. Metge.(1)***
10.30 -- Lease by and between Digex and Riggs & Company, dated as of
June 29, 2000.(3)***
10.31 -- Amendment No. 2, dated as of June 29, 2000, to the General
and Administrative Services Agreement between Digex and
Intermedia.***
10.32 -- Asset Migration Agreement, dated as of June 1, 2000, between
Digex and Intermedia.***
10.33 -- Letter Agreement dated July 31, 2000 between Digex and Lemis
O. Altan.(1)****
10.34 -- Amended and Restated Guaranty Agreement, dated as of October
31, 2000, by Digex, as Guarantor, on behalf of Bank of
America, N.A., as Administrative Agent for Lenders, amending
and restating the Guaranty Agreement, dated as of December
22, 1999, by Digex, as Guarantor, on behalf of Bank of
America N.A., as Administrative Agent for Lenders.****
10.35 -- Amended and Restated Security Agreement, dated as of October
31, 2000, between Digex, as Debtor, and Bank of America,
N.A., as the Secured Party on behalf of Lenders, amending
and restating the Security Agreement, dated as of December
22, 1999, between Digex, as Debtor, and Bank of America,
N.A., as the Secured Party on behalf of Lenders.****
10.36 -- Amendment, dated as of October 24, 2000, to the Use of
Proceeds Agreement between Digex and Intermedia, dated as of
January 24, 2000.****
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EXHIBIT
NUMBERS DESCRIPTION
- ------- -----------
10.37 -- Employment Letter dated October 26, 2000 between Digex and
Howard Weizmann.(1)
10.38 -- Master Channel Agreement between Digex and MCI WorldCom
Network Services, Inc., dated as of January 1, 2001.
Incorporated herein by reference to Digex's Form 8-K (File
No. 000-26873) filed with the SEC on March 5, 2001.
10.39 -- Master Facilities Agreement between Digex and MCI WorldCom
Network Services, Inc., dated as of January 1, 2001.
Incorporated herein by reference to Digex's Form 8-K (File
No. 000-26873) filed with the SEC on March 5, 2001.
23.1 -- Consent of Ernst & Young LLP.
- ---------------
(1) Management contract or compensatory plan or arrangement.
(2) Confidential treatment of certain provisions of this exhibit was requested
and granted by the SEC in connection with the filing of Digex's
registration statement on Form S-1 (File No. 333-77105).
(3) Confidential treatment of certain provisions of this exhibit was requested
and granted by the SEC in connection with the filing of Digex's Form 10-Q
for the quarter ended June 30, 2000 (File No. 000-26873) filed with the
SEC on August 14, 2000.
* Incorporated herein by reference to Digex's registration statement on
Form S-1 (File No. 333-77105) filed with the SEC.
** Incorporated herein by reference to Digex's registration statement on Form
S-1 (File No. 333-94879) filed with the SEC.
*** Incorporated herein by reference to Digex's Form 10-Q for the quarter
ended June 30, 2000 (File No. 000-26873) filed with the SEC on August 14,
2000.
**** Incorporated herein by reference to Digex's Form 10-Q for the quarter
ended September 30, 2000 (File No. 000-26873) filed with the SEC on
November 14, 2000.
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(b) Reports on Form 8-K
The following Current Reports on Form 8-K were filed during the fourth
quarter of 2000:
Digex filed a Current Report on Form 8-K, dated October 13, 2000, reporting
under Item 5 reporting the filing of multiple shareholder complaints against
Intermedia, Digex, certain interested directors of Digex, and WorldCom in
connection with the Merger Agreement between Intermedia and WorldCom. The
Company also reported under Item 7 the filing of the complaint as an exhibit to
the Form 8-K.
Digex filed a Current Report on Form 8-K, dated October 26, 2000, reporting
under Item 5 reporting the filing of a consolidated shareholders complaint
against Intermedia, Digex, certain interested directors of Digex, and WorldCom.
The Company also reported under Item 7 the filing of the complaint as an exhibit
to the Form 8-K.
Digex filed a Current Report on Form 8-K, dated October 27, 2000, reporting
under Item 5 the issuance of a press release discussing Digex's third quarter
results. The Company also reported under Item 7 the filing of the press release
as an exhibit to the Form 8-K.
Digex filed a Current Report on Form 8-K, dated November 20, 2000,
reporting under Item 9 Regulation FD Disclosure discussing its Analyst Day
presentation to financial analysts and others. The Company also reported under
Item 7 the filing of selected presentation slides as an exhibit to the Form 8-K.
Digex filed a Current Report on Form 8-K, dated December 15, 2000,
reporting under Item 5 reporting the Legal Opinion of the Court of Chancery of
the State of Delaware in and for New Castle County In Re: Digex, Inc.
Shareholders Litigation, dated December 13, 2000. The Company also reported
under Item 7 the filing of the Opinion as an exhibit to the Form 8-K.
46
49
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
Dated: April 2, 2001.
DIGEX, INCORPORATED
(Registrant)
By: /s/ MARK K. SHULL
------------------------------------
Mark K. Shull
President and Chief Executive
Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
PRINCIPAL EXECUTIVE OFFICER:
/s/ MARK K. SHULL Director, President and Chief April 2, 2001
- ----------------------------------------------- Executive Officer
Mark K. Shull
PRINCIPAL FINANCIAL AND ACCOUNTING OFFICERS:
/s/ TIMOTHY M. ADAMS Chief Financial Officer April 2, 2001
- -----------------------------------------------
Timothy M. Adams
/s/ T. SCOTT ZIMMERMAN Vice President and Controller April 2, 2001
- -----------------------------------------------
T. Scott Zimmerman
DIRECTORS:
/s/ DAVID C. RUBERG Chairman of the Board April 2, 2001
- -----------------------------------------------
David C. Ruberg
/s/ JOHN C. BAKER Director April 2, 2001
- -----------------------------------------------
John C. Baker
/s/ PHILIP A. CAMPBELL Director April 2, 2001
- -----------------------------------------------
Philip A. Campbell
/s/ RICHARD A. JALKUT Director April 2, 2001
- -----------------------------------------------
Richard A. Jalkut
/s/ ROBERT M. MANNING Director April 2, 2001
- -----------------------------------------------
Robert M. Manning
/s/ JACK E. REICH Director April 2, 2001
- -----------------------------------------------
Jack E. Reich
47
50
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Digex, Incorporated
We have audited the accompanying consolidated balance sheets of Digex,
Incorporated as of December 31, 2000 and 1999, and the related consolidated
statements of operations, stockholders' equity and cash flows for each of the
three years in the period ended December 31, 2000. Our audits also included the
financial statement schedule listed in the Index at Item 14(a). These financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Digex, Incorporated at December 31, 2000 and 1999, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended December 31, 2000, in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
As discussed in Note 1 to the consolidated financial statements, in 2000
the Company changed its method of accounting for revenue recognition.
/s/ ERNST & YOUNG LLP
--------------------------------------
McLean, Virginia
January 30, 2001
Except for Notes 13 and 15, as to which the date is
March 2, 2001
F-1
51
DIGEX, INCORPORATED
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT SHARE INFORMATION)
DECEMBER 31,
-------------------
2000 1999
-------- --------
ASSETS
Current assets:
Cash and cash equivalents................................. $ 83,434 $ 88,778
Restricted investments.................................... 2,000 --
Accounts receivable, net of allowance of $4,741 and $4,362
in 2000 and 1999, respectively......................... 42,201 17,271
Due from Intermedia....................................... 40 3,110
Deferred costs............................................ 8,627 --
Prepaid expenses and other current assets................. 7,452 1,496
-------- --------
Total current assets.............................. 143,754 110,655
Property and equipment, net................................. 348,975 205,903
Intangible assets, net...................................... 23,222 27,213
Other assets................................................ 5,100 538
-------- --------
Total assets...................................... $521,051 $344,309
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses..................... $ 59,455 $ 33,619
Current portion of deferred revenue....................... 7,734 222
Current portion of note payable........................... 2,772 1,235
Current portion of capital lease obligations.............. 1,871 801
-------- --------
Total current liabilities......................... 71,832 35,877
Deferred revenue............................................ 4,025 --
Note payable................................................ 1,435 2,477
Capital lease obligations................................... 27,131 15,766
-------- --------
Total liabilities................................. 104,423 54,120
-------- --------
Stockholders' equity:
Preferred stock, $.01 par value; 5,000,000 shares
authorized; 100,000 shares designated as Series A
Convertible; 100,000 Series A Convertible shares issued
and outstanding in 2000................................ 1 --
Class A common stock, $.01 par value; 100,000,000 shares
authorized; 24,546,543 and 11,500,000 shares issued and
outstanding in 2000 and 1999, respectively............. 245 115
Class B common stock, $.01 par value; 50,000,000 shares
authorized; 39,350,000 and 50,000,000 issued and
outstanding in 2000 and 1999, respectively............. 394 500
Additional capital........................................ 622,036 354,553
Accumulated deficit....................................... (195,869) (52,768)
Deferred compensation..................................... (10,141) (12,211)
Accumulated other comprehensive loss...................... (38) --
-------- --------
Total stockholders' equity........................ 416,628 290,189
-------- --------
Total liabilities and stockholders' equity........ $521,051 $344,309
======== ========
See accompanying notes to consolidated financial statements.
F-2
52
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
YEAR ENDED DECEMBER 31,
---------------------------------------
2000 1999 1998
----------- ----------- -----------
Revenues................................................ $ 168,085 $ 59,786 $ 22,635
Costs and expenses:
Cost of operations.................................... 21,244 9,656 6,710
Cost of services...................................... 69,658 21,750 7,044
Selling, general and administrative................... 144,876 70,213 17,512
Deferred compensation................................. 4,101 1,299 --
Depreciation and amortization......................... 78,819 29,070 8,109
----------- ----------- -----------
Total costs and expenses...................... 318,698 131,988 39,375
----------- ----------- -----------
Loss from operations.................................... (150,613) (72,202) (16,740)
Other income (expense):
Interest expense...................................... (2,008) (1,094) --
Interest and other income............................. 12,608 3,458 --
Merger-related expenses............................... (2,922) -- --
----------- ----------- -----------
Loss before income tax benefit.......................... (142,935) (69,838) (16,740)
Income tax benefit...................................... -- 4,839 159
----------- ----------- -----------
Loss before cumulative effect of change in accounting
principle............................................. (142,935) (64,999) (16,581)
Cumulative effect of change in accounting principle..... (166) -- --
----------- ----------- -----------
Net loss................................................ $ (143,101) $ (64,999) $ (16,581)
=========== =========== ===========
LOSS PER COMMON SHARE -- BASIC AND DILUTED:
Loss before cumulative effect of change in accounting
principle............................................. $ (2.25) $ (1.19) $ (0.33)
Cumulative effect of change in accounting principle..... (0.01) -- --
----------- ----------- -----------
Net loss per common share............................... $ (2.26) $ (1.19) $ (0.33)
=========== =========== ===========
PRO FORMA AMOUNTS, ASSUMING THE ACCOUNTING CHANGE IS
APPLIED RETROACTIVELY:
Net loss................................................ $ (142,935) $ (65,115) $ (16,618)
=========== =========== ===========
Net loss per common share............................... $ (2.25) $ (1.19) $ (0.33)
=========== =========== ===========
Shares used in computing basic and diluted net loss per
share................................................. 63,404,839 54,726,027 50,000,000
=========== =========== ===========
See accompanying notes to consolidated financial statements.
F-3
53
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
COMMON STOCK
----------------------------------
PREFERRED STOCK CLASS A CLASS B
--------------- --------------- ---------------- ADDITIONAL ACCUMULATED
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT CAPITAL DEFICIT
------ ------ ------ ------ ------- ------ ---------- -----------
BALANCE AT DECEMBER 31, 1997............ -- -- -- -- -- -- -- --
Total allocated costs................... -- -- -- -- -- -- -- --
Funding for working capital............. -- -- -- -- -- -- -- --
Funding for purchases of property, plant
and equipment......................... -- -- -- -- -- -- -- --
Net loss................................ -- -- -- -- -- -- -- --
------ ------ ------ ------ ------- ------ ---------- -----------
BALANCE AT DECEMBER 31, 1998............ -- -- -- -- -- -- -- --
Total allocated costs................... -- -- -- -- -- -- -- --
Funding for working capital............. -- -- -- -- -- -- -- --
Funding for purchases of property, plant
and equipment......................... -- -- -- -- -- -- -- --
Recapitalization by Intermedia.......... -- -- -- -- 50,000 500 114,566 --
Contributions from Intermedia following
recapitalization...................... -- -- -- -- -- -- 47,689 --
Initial public offering of common stock,
net of issuance cost.................. -- -- 11,500 115 -- -- 178,788 --
Issuance of stock options under
long-term compensation plan........... -- -- -- -- -- -- 13,510 --
Amortization of deferred compensation... -- -- -- -- -- -- -- --
Net loss................................ -- -- -- -- -- -- -- (52,768)
------ ------ ------ ------ ------- ------ ---------- -----------
BALANCE AT DECEMBER 31, 1999............ -- -- 11,500 115 50,000 500 354,553 (52,768)
Issuance of Series A Convertible
preferred stock, net of available
equipment credits..................... 100 1 -- -- -- -- 87,669 --
Subsequent public offering of common
stock, net of issuance cost........... -- -- 12,650 126 (10,650) (106) 171,625 --
Issuance of stock options under
long-term compensation plan, net of
forfeitures........................... -- -- -- -- -- -- 2,067 --
Exercise of common stock options........ -- -- 397 4 -- -- 6,122 --
Amortization of deferred compensation... -- -- -- -- -- -- -- --
Foreign currency translation
adjustment............................ -- -- -- -- -- -- -- --
Net loss................................ -- -- -- -- -- -- -- (143,101)
------ ------ ------ ------ ------- ------ ---------- -----------
BALANCE AT DECEMBER 31, 2000............ 100 $ 1 24,547 $ 245 39,350 $ 394 $ 622,036 $ (195,869)
====== ====== ====== ====== ======= ====== ========== ===========
ACCUMULATED OWNER'S
OTHER NET
DEFERRED COMPREHENSIVE INVESTMENT
COMPENSATION LOSS (DEFICIT) TOTAL
------------ ------------- ---------- ---------
BALANCE AT DECEMBER 31, 1997............ -- -- $ 45,527 $ 45,527
Total allocated costs................... -- -- 10,018 10,018
Funding for working capital............. -- -- 912 912
Funding for purchases of property, plant
and equipment......................... -- -- 30,969 30,969
Net loss................................ -- -- (16,581) (16,581)
------------ ------------- ---------- ---------
BALANCE AT DECEMBER 31, 1998............ -- -- 70,845 70,845
Total allocated costs................... -- -- 3,541 3,541
Funding for working capital............. -- -- 11,443 11,443
Funding for purchases of property, plant
and equipment......................... -- -- 89,574 89,574
Recapitalization by Intermedia.......... -- -- (115,066) --
Contributions from Intermedia following
recapitalization...................... -- -- (48,106) (417)
Initial public offering of common stock,
net of issuance cost.................. -- -- -- 178,903
Issuance of stock options under
long-term compensation plan........... (13,510) -- -- --
Amortization of deferred compensation... 1,299 -- -- 1,299
Net loss................................ -- -- (12,231) (64,999)
------------ ------------- ---------- ---------
BALANCE AT DECEMBER 31, 1999............ (12,211) -- -- 290,189
Issuance of Series A Convertible
preferred stock, net of available
equipment credits..................... -- -- -- 87,670
Subsequent public offering of common
stock, net of issuance cost........... -- -- -- 171,645
Issuance of stock options under
long-term compensation plan, net of
forfeitures........................... (2,067) -- -- --
Exercise of common stock options........ -- -- -- 6,126
Amortization of deferred compensation... 4,137 -- -- 4,137
Foreign currency translation
adjustment............................ -- (38) -- (38)
Net loss................................ -- -- -- (143,101)
------------ ------------- ---------- ---------
BALANCE AT DECEMBER 31, 2000............ $ (10,141) $ (38) -- $ 416,628
============ ============= ========== =========
See accompanying notes to consolidated financial statements.
F-4
54
DIGEX, INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
YEAR ENDED DECEMBER 31,
--------------------------------
2000 1999 1998
--------- --------- --------
OPERATING ACTIVITIES:
Net loss.................................................. $(143,101) $ (64,999) $(16,581)
Cumulative effect of change in accounting principle....... 166 -- --
--------- --------- --------
Loss before cumulative effect of accounting change........ (142,935) (64,999) (16,581)
Adjustments to reconcile net loss to cash used in
operating activities:
Depreciation and amortization.......................... 78,819 29,070 8,109
Provision for doubtful accounts........................ 10,649 4,265 1,491
Amortization of deferred compensation.................. 4,137 1,299 --
Loss on sale/disposals of telecommunications
equipment............................................ 655 52 --
Deferred income taxes.................................. -- (4,839) (159)
Accretion of interest on note payable and capital lease
obligation........................................... 467 -- --
Changes in operating assets and liabilities:
Accounts receivable.................................... (35,612) (15,409) (5,559)
Due from Intermedia.................................... 3,077 (3,110) --
Deferred costs......................................... (8,627) -- --
Prepaid expenses and other current assets.............. (5,956) (606) (550)
Other assets........................................... (4,562) (79) (459)
Accounts payable and accrued expenses.................. 25,997 33,619 2,778
Deferred revenue....................................... 11,371 222 --
--------- --------- --------
Net cash used in operating activities..................... (62,520) (20,515) (10,930)
INVESTING ACTIVITIES:
Purchases of property and equipment....................... (202,604) (170,396) (30,969)
Purchase of restricted investments........................ (2,000) -- --
Proceeds from sale of telecommunication assets............ -- 203 --
--------- --------- --------
Net cash used in investing activities..................... (204,604) (170,193) (30,969)
FINANCING ACTIVITIES:
Proceeds from subsequent public offering, net of costs.... 171,645 -- --
Proceeds from issuance of preferred stock................. 85,000 -- --
Proceeds from exercise of common stock options............ 6,126 -- --
Principal payments on long-term note payable and capital
leases................................................. (953) (1,424) --
Proceeds from initial public offering, net of costs....... -- 178,903 --
Net contributions from Intermedia......................... -- 102,007 41,899
--------- --------- --------
Net cash provided by financing activities................. 261,818 279,486 41,899
Effect of exchange rate on cash and cash equivalents........ (38) -- --
Net increase in cash and cash equivalents................... (5,344) 88,778 --
Cash and cash equivalents at beginning of the year.......... 88,778 -- --
--------- --------- --------
Cash and cash equivalents at end of year.................... $ 83,434 $ 88,778 $ --
========= ========= ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Assets acquired through capital leases.................... $ 13,249 $ 17,111 $ 958
Asset purchase financed by note payable................... -- 4,672 --
Interest paid............................................. 1,696 1,010 --
See accompanying notes to consolidated financial statements.
F-5
55
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION, BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION
Digex, Incorporated ("Digex") was incorporated on April 26, 1999, under the
laws of the State of Delaware. Digex's business was operated as the Web site
hosting unit of Intermedia Communications Inc. ("Intermedia") since its
acquisition by Intermedia on July 7, 1997. On that date, Intermedia acquired
Business Internet, Inc. (previously known as DIGEX, Incorporated), including the
Web site hosting unit, in a business combination accounted for as a purchase.
The Web site hosting unit presented in the accompanying financial statements had
no legal status or existence prior to the incorporation of Digex on April 26,
1999. Prior to April 30, 1999, Digex had no assets or liabilities.
Digex's predecessor operations began in January 1996 to provide managed Web
hosting services, principally to Fortune 2000 companies. Digex's services
include implementing and maintaining secure, scalable, high performance Web
sites on the Internet 24 hours a day. In addition, Digex provides a
comprehensive suite of Web management services, including business process
solutions and value-added testing services directed toward improving its
customers' overall Internet performance.
On July 11, 2000, Intermedia announced that it was exploring strategic
alternatives with regard to Digex, including, without limitation, the possible
sale of its ownership position in Digex. On September 1, 2000, Intermedia
entered into a merger agreement with WorldCom, Inc. ("WorldCom") whereby, upon
consummation of the merger, a subsidiary of WorldCom will be merged with and
into Intermedia and Intermedia will become a subsidiary of WorldCom (the
"Intermedia -- WorldCom Merger"). As a result of the merger, WorldCom will
beneficially own a majority of the capital stock of Digex and will have voting
control of Digex. The merger is expected to be consummated in the second quarter
of 2001.
BASIS OF PRESENTATION
The accompanying consolidated financial statements include the accounts of
Digex and its wholly-owned subsidiaries. All significant intercompany accounts
and transactions have been eliminated in consolidation. The consolidated
financial statements reflect, in the opinion of management, all adjustments,
which are of a normal and recurring nature, necessary for a fair presentation of
the financial condition and results of operations and cash flows for the periods
presented. Certain prior period amounts have been reclassified to conform to the
current period presentation.
The financial statements for periods prior to April 30, 1999 represent the
carved-out operations of the managed Web and application hosting unit of
Intermedia. Digex's accumulated deficit of $195.9 million arose after April 30,
1999. Accumulated losses and capital contributions from Intermedia were included
in owner's net investment prior to April 30, 1999 and were transferred to
additional capital upon the capitalization of Digex. Intermedia contributed
approximately $115.1 million in assets and certain liabilities on April 30,
1999. Intermedia also contributed additional capital of $48.1 million to Digex
beginning May 1 through August 4, 1999, principally by way of contributions of
telecommunications assets. These contributions were accounted for at
Intermedia's underlying book values on the date of contribution. As more fully
discussed in Note 2, "Related Party Corporate Allocations," the financial
statements for 1998 and 1999 include allocations of network costs and corporate
expenses. In addition, for financial reporting purposes, the equity activity of
Digex prior to its incorporation has been accumulated into a single disclosure
caption entitled "Owner's Net Investment."
F-6
56
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates
The preparation of financial statements in accordance with generally
accepted accounting principles requires management to make estimates and
assumptions. Such estimates and assumptions affect the reported amounts of
assets and liabilities, as well as the disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenue and expenses during the reporting period. Actual results could differ
from those estimates.
Cash Equivalents
Digex considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.
Property and Equipment
Property and equipment is stated at cost. Depreciation is computed using
the straight-line method over the estimated useful lives of the property and
equipment, ranging from three years for electronics to five years for furniture
and office equipment. Buildings under capital leases and leasehold improvements
are amortized over the lesser of the lease term or the useful life. Property and
equipment acquired under capital leases is amortized using the straight-line
method over the lesser of the lease term or the estimated useful life of the
asset.
Intangible Assets
Intangible assets include assets that arose in connection with the purchase
of Business Internet, Inc. by Intermedia. Identifiable intangible assets arising
from the purchase are stated at cost and consist of trade name, customer lists,
acquired workforce, developed technology and goodwill. Amortization of these
assets is computed using the straight-line method over the estimated periods of
benefit, generally five years for developed technologies and ten years for all
other intangible assets.
Impairment of Long-Lived Assets
In accordance with Statement of Financial Accounting Standards (SFAS) No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of, Digex reviews its long-lived assets for impairment
when events or changes in circumstances indicate the carrying value of such
assets may not be recoverable. This review consists of a comparison of the
carrying value of the asset with the asset's expected future undiscounted cash
flows without interest costs. Estimates of expected future cash flows represent
management's best estimate based on reasonable and supportable assumptions and
projections. If the expected future cash flow exceeds the carrying value of the
asset, no impairment indicator is considered present. If the carrying value
exceeds the future cash flow, an impairment indicator is considered present.
Such impairment would be measured and recognized using a discounted cash flow
method.
Financial Instruments
The carrying value of Digex's financial instruments, including cash and
cash equivalents, restricted investments, accounts receivable, accounts payable,
note payable and capital lease obligations approximate their fair market values.
F-7
57
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Revenue Recognition
Revenues principally consist of installation fees and monthly service fees
charged to customers under contracts having terms that typically range from one
to three years. Installation fees along with related costs are deferred and
recognized over the contract period. Monthly services fees are recognized in the
month the service is rendered. Certain customer payments for managed Web hosting
services received in advance of service delivery are deferred until the service
is performed. Additional services are recognized in the month the services are
performed. Refer to "Change in Accounting Principle" in Note 1 to the
consolidated financial statements for further discussion.
Advertising Costs
Digex expenses advertising costs as incurred. Advertising expense amounted
to $21.9 million in 2000, $6.8 million in 1999, and $2.5 million in 1998 and is
included in the consolidated statements of operations as selling, general and
administrative expense.
Research and Development Costs
Digex expenses research and development costs ("R&D costs") as incurred,
except for equipment that have alternative future uses, in accordance with SFAS
No. 2, Accounting for Research and Development Costs. Indirect costs and general
administrative expenses directly related to a joint development project and
normal business development activities are expensed as incurred. R&D costs
amounted to $9.5 million in 2000, $0.6 million in 1999, and $1.0 million in 1998
and are included in the consolidated statements of operations as selling,
general, and administrative expense.
Costs incurred in the research and development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility has been established. After technological feasibility
is established, any additional development costs are capitalized in accordance
with SFAS No. 86, Accounting For The Costs of Computer Software To Be Sold,
Leased, Or Otherwise Marketed. Product development costs incurred for internal
use software are expensed as incurred until the application development state,
after which costs are capitalized in accordance with Statement of Position 98-1,
Accounting for the Costs of Computer Software Developed or Obtained for Internal
Use.
Stock-Based Compensation
Digex accounts for employee stock-based compensation in accordance with
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations. Accordingly, in cases where exercise
prices at the date of grant equal or exceed fair market value of the underlying
common stock, Digex recognizes no compensation expense. In cases where exercise
prices at the date of grant are less than the fair value, compensation is
recognized over the period of performance or vesting period.
Income Taxes
Digex accounts for income taxes under the provisions of SFAS No. 109,
Accounting for Income Taxes. SFAS No. 109 requires recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been included in the financial statements or tax returns. Under this
method, deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse.
F-8
58
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Loss Per Share
Digex has applied the provisions of SFAS No. 128, Earnings Per Share, which
establishes standards for computing and presenting earnings per share. Basic
earnings per share is computed by dividing income available to common
stockholders by the weighted average number of common shares outstanding for the
period.
Comprehensive Income
In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS
No. 130, Reporting Comprehensive Income. This standard requires that total
comprehensive income (loss) be disclosed with equal prominence as net income.
Comprehensive income is defined as changes in stockholder's equity exclusive of
transactions with owners, such as capital contributions and dividends. Digex
adopted this standard in 1998 and implemented the standard for all years
presented herein. Digex's only component of accumulated other comprehensive
income for 2000 resulted from foreign currency translation. Comprehensive losses
were equal to net losses for 1999 and 1998.
Foreign Currency Translation
The financial statements of foreign subsidiaries have been translated into
U.S. dollars in accordance with SFAS No. 52, Foreign Currency Translation. All
balance sheet accounts have been translated using the exchange rates in effect
at the balance sheet date. Income statement amounts have been translated using
the average exchange rate for the period. Foreign currency translation
adjustments are reported as a component of accumulated other comprehensive
income within stockholders' equity. The gains and losses of $0.07 million
resulting from foreign currency transactions are reported in the results of
operations in 2000.
Concentrations of Credit Risk
Financial instruments that potentially expose Digex to credit risk consist
primarily of cash and cash equivalents, restricted investments and accounts
receivable.
Digex places its cash and temporary cash investments with high-quality
institutions. Fair value of the restricted investment approximates the cost due
to the short period of time to maturity.
Accounts receivable are due from commercial entities to whom credit is
extended based on evaluation of the customer's financial condition, and in
certain cases collateral is required. Anticipated credit losses are provided for
in the consolidated financial statements and have been within management's
expectations for all periods presented. As of December 31, 2000, Digex does not
have any significant concentrations of business transacted with a particular
customer, supplier or lender that could, if suddenly eliminated, severely impact
its operations.
Change in Accounting Principle
Effective January 1, 2000, Digex changed its method of accounting for
revenue recognition in accordance with Staff Accounting Bulletin No. 101 ("SAB
101"), Revenue Recognition in Financial Statements. Historically, Digex has
recognized installation revenue, in accordance with industry practice, upon
completion of the managed Web hosting solution. The direct costs associated with
the installation were expensed as incurred. Under the new accounting method
adopted retroactive to January 1, 2000, Digex now recognizes installation
revenue and related direct incremental costs of performing the installation over
the contract term (generally 24 months).
The cumulative effect of the change on prior years resulted in a net charge
of $0.2 million ($5.3 million revenue less related direct incremental costs),
which is included in the Consolidated Statement of Operations
F-9
59
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
for the year ended December 31, 2000. The effect of the change on the year ended
December 31, 2000 was to increase net loss before the cumulative effect of the
accounting change by $0.25 million (less than $0.01 per share). For the year
ended December 31, 2000, Digex recognized revenue of $4.6 million and direct
incremental costs of $4.4 million that was included in the cumulative effect
adjustment as of January 1, 2000. With the adoption of SAB 101, there was no
economic impact to Digex's business operations or cash flows. There was also no
material effect to Digex's consolidated financial statements. The pro forma
amounts presented in the Consolidated Statements of Operations were calculated
assuming the accounting change was made retroactively to prior periods.
Recent Accounting Pronouncements
In June 2000, the FASB issued SFAS No. 138, Accounting for Certain
Derivative Instruments and Certain Hedging Activities, an amendment of SFAS No.
133, which is effective for fiscal years beginning after June 15, 2000. Digex
anticipates that the adoption of SFAS No. 133, as amended, will not have a
significant effect on its consolidated financial statements.
2. RELATED PARTY CORPORATE ALLOCATIONS
Prior to August 4, 1999, Digex utilized the central cash management systems
of Business Internet and Intermedia. Cash requirements during these periods were
satisfied by cash transactions and transfers that were accounted for through an
intercompany account. In addition, Intermedia charged Digex for identifiable
corporate and operating expenses, such as network cost and corporate overhead
cost. Intercompany account balances for periods prior to July 29, 1999 have been
treated as permanent contributions and have been reflected as a component of
owner's net investment in the accompanying consolidated financial statements.
The following table summarizes corporate charges and allocations included
in the accompanying consolidated financial statements (in thousands):
STATEMENT OF OPERATIONS CAPTION 1999 1998
- ------------------------------- ------- -------
Cost of operations................................... $ 9,190 $ 6,494
Cost of services..................................... 494 1,320
Selling, general and administrative.................. 18,123 2,204
------- -------
$27,807 $10,018
======= =======
Amounts presented for 1999 in the table above include expenses recorded as
a result of certain related party agreements with Intermedia. Management
believes that the allocation methodology applied is reasonable. However, it was
not practicable to determine whether the allocated amounts represent amounts
that would have been incurred on a standalone basis. Explanations of the
composition and the method of allocation for the above captions are as follows:
Cost of Operations
Allocated costs within this caption were the costs of telecommunications
backbone circuits. These costs were allocated to Digex based upon circuit usage
and rate information.
Cost of Services
Allocated costs within this caption were the costs associated with two data
centers (maintenance, utilities and support and employment costs for network
engineering and support, and certain other overhead). These costs were allocated
based upon the employee base.
F-10
60
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Selling, General and Administrative
Allocated costs within this caption were the costs of human resources,
information systems services, accounting and back office support, executive
salaries and other general and administrative costs, including rent. All costs
except accounting and back office support were allocated based upon the employee
base. Accounting and back office support were allocated based upon the relative
percentage of monthly recurring revenues.
Refer to Note 11 to the consolidated financial statements for additional
related party transactions and agreements.
3. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following (in thousands):
DECEMBER 31,
---------------------
2000 1999
--------- --------
Buildings......................................... $ 30,178 $ 17,344
Electronics and computer equipment................ 276,587 126,389
Computer software................................. 54,845 29,053
Furniture and office equipment.................... 8,532 2,427
Leasehold improvements............................ 84,485 61,981
--------- --------
455,627 237,194
Less accumulated depreciation and amortization.... (105,652) (31,291)
--------- --------
$ 348,975 $205,903
========= ========
Property and equipment included buildings, electronics and computer
equipment, and furniture and office equipment of $30.5 million and $20.3 million
at December 31, 2000 and 1999, respectively, that were capitalized pursuant to
the terms of capital lease agreements. Accumulated amortization of assets
recorded under capital leases amounted to $3.4 million and $1.3 million at
December 31, 2000 and 1999, respectively. Amortization of these assets is
included in depreciation and amortization expense.
4. INTANGIBLE ASSETS
Intangible assets consisted of the following (in thousands):
DECEMBER 31,
-------------------
2000 1999
-------- -------
Goodwill............................................ $ 19,099 $19,099
Trade name.......................................... 9,750 9,750
Customer list....................................... 3,120 3,120
Developed technologies.............................. 2,720 2,720
Acquired workforce.................................. 1,253 1,253
-------- -------
35,942 35,942
Less accumulated amortization....................... (12,720) (8,729)
-------- -------
$ 23,222 $27,213
======== =======
Amortization expense amounted to $4.0 million in 2000, $4.0 million in 1999
and $3.2 million in 1998.
F-11
61
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. STOCKHOLDERS' EQUITY
In connection with the recapitalization, Digex filed a Certificate of
Incorporation and certain amendments in the state of Delaware. Pursuant to the
Certificate, as amended, the number of authorized shares of common stock is
150,000,000 (including 100,000,000 Class A shares and 50,000,000 Class B shares)
and the number of authorized shares of preferred stock is 5,000,000 shares. The
Class A and Class B common stock are identical in all respects except that the
Class A is entitled to one vote for each share and the Class B is entitled to
ten votes for each share.
On August 4, 1999, Digex sold 11,500,000 shares of its Class A Common Stock
in an initial public offering (also referred to as the "Offering"). The shares
sold represented approximately 18.7% of the aggregate number of shares of Class
A and Class B Common Stock then outstanding. After the Offering, Intermedia
retained a 97.8% voting interest in the Company. The net proceeds from the
Offering were approximately $178.9 million and could be used only to purchase
telecommunications related assets due to restrictions in Intermedia's debt
instruments.
On January 12, 2000, Digex sold 100,000 shares of its non-voting preferred
stock, designated as Series A Convertible Preferred Stock (the "Preferred
Stock"), with detachable warrants to purchase 1,065,000 shares of its Class A
Common Stock (the "Warrants"), for an aggregate of $100.0 million, of which
$15.0 million was in the form of equipment purchase credits. Of the $15.0
million of equipment purchase credits, approximately $2.7 million was used for
equipment purchases in 2000. The remaining credit of $12.3 million is netted
against stockholders' equity as of December 31, 2000. The Preferred Stock has an
aggregate liquidation preference of $100.0 million, and is convertible into
approximately 1,462,000 shares of Class A Common Stock. The Warrants can be
exercised at any time over their three-year term at a price of $57.00 per share
(the fair value of Digex's Class A Common Stock on the transaction commitment
date). The proceeds from the offering was allocated between the Preferred Stock
and the Warrants based upon their relative fair values.
On February 16, 2000, Digex completed a public offering of 12,650,000
shares of Class A Common Stock. Digex sold 2,000,000 shares of Class A Common
Stock and received net proceeds of approximately $171.6 million. Intermedia sold
10,650,000 shares of Class B Common Stock. The Class B Common Stock sold by
Intermedia automatically converted into Class A Common Stock at the closing of
the offering. Each share of Class B Common Stock is entitled to 10 votes while
each share of Class A Common Stock is entitled to one vote. As a result, while
Intermedia owns approximately 61.6% of Digex's equity interests, it controls
approximately 94.1% of Digex's voting interest as of December 31, 2000.
6. DEFERRED COMPENSATION
Since July 29, 1999, Digex granted options to purchase 1,241,250 shares
(net of 188,750 forfeited options) of Class A Common Stock under the Digex Long
Term Incentive Plan to certain employees of Digex at exercise prices below
market value. Digex recorded deferred compensation of $4.2 million in 2000 and
$13.5 million in 1999, a separate component of stockholders' equity, to be
expensed over the four-year vesting period of the options. Deferred compensation
was reduced by $2.1 million in the year ended December 31, 2000 for forfeited
stock options. Deferred compensation expense of $4.1 million and $1.3 million
was recorded during the years ended December 31, 2000 and 1999, respectively.
7. EMPLOYEE BENEFIT PLANS
Stock-based Compensation Plan
Under the provisions of the Intermedia 1996 Long-Term Incentive Plan (1996
Plan), certain employees and directors of Digex were granted options to buy
shares of Intermedia common stock, generally at market value with terms of five
to ten years.
F-12
62
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Digex Long-Term Incentive Plan adopted on July 23, 1999 (1999 Plan) and
administered by the compensation committee of the Board of Directors permits
awards of stock, stock options, stock appreciation rights, restricted stock and
other stock-based awards as incentives to current and prospective employees,
officers, directors and consultants, and those of Digex's subsidiaries or of any
person that owns over 50% of the voting power of our authorized and outstanding
voting shares. Stock options are generally vested over a four-year period for
officers and employees. Exercisable options expire ten years following the date
of the grant.
On June 1, 2000, a majority of Digex stockholders ratified the Board's
amendment to the 1999 Plan, increasing the aggregate number of shares of Class A
Common Stock authorized for issuance under the 1999 Plan to 15,000,000 shares.
As of December 31, 2000, the Board has 6,677,408 shares of Common Stock reserved
for issuance to employees, officers, directors, and consultants of Digex
pursuant to the 1999 Plan.
The following table summarizes the stock option activity related to
employees of Intermedia and Digex:
NUMBER OF PER SHARE
SHARES OPTION PRICE
---------- -------------
Outstanding Intermedia options at December 31,
1997............................................. 359,988 $ 0.26- 10.82
Granted.......................................... 130,900 16.38- 37.00
Exercised........................................ (87,521) 0.26- 10.82
Canceled......................................... (183,187) 0.26- 37.00
---------- -------------
Outstanding Intermedia options at December 31,
1998............................................. 220,180 $ 0.26- 37.00
========== =============
Digex options granted on July 29, 1999............. 5,031,500 $ 5.00- 17.00
Granted.......................................... 1,360,170 5.00- 54.19
Exercised........................................ -- --
Canceled......................................... (687,650) 17.00- 54.19
---------- -------------
Outstanding Digex options at December 31, 1999..... 5,704,020 5.00- 54.19
Granted.......................................... 4,545,993 11.00-139.38
Exercised........................................ (396,543) 5.00- 29.13
Canceled......................................... (1,927,421) 5.00-139.38
---------- -------------
Outstanding Digex options at December 31, 2000..... 7,926,049 $ 5.00-139.38
========== =============
Exercisable Intermedia options at December 31,
1998............................................. 75,244 $ 0.26- 37.00
========== =============
Exercisable Digex options at December 31, 1999..... 30,000 $ 17.00
========== =============
Exercisable Digex options at December 31, 2000..... 1,320,256 $ 5.00- 54.19
========== =============
Digex has adopted the disclosure only provisions of SFAS No. 123,
Accounting for Stock Compensation. Pro forma net loss and net loss per share,
assuming that Digex had applied the fair value model (Black-Scholes Pricing
Model) required by SFAS No. 123, is as follows (in thousands):
YEAR ENDED DECEMBER 31,
-------------------------------
2000 1999 1998
--------- -------- --------
Net loss.................................. $(185,803) $(71,800) $(16,828)
Net loss per share........................ $ (2.93) $ (1.31) $ (0.34)
F-13
63
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table summarizes the significant assumptions used in
developing the information:
YEAR ENDED DECEMBER 31,
---------------------------
2000 1999 1998
------- ------- -------
Risk-free interest rate......................... 5.5% 5.6% 5.4%
Volatility factor............................... 1.379 .60 .53
Dividend yield.................................. -- -- --
Weighted average life........................... 5 years 5 years 5 years
The following table summarizes the weighted average exercise prices of
option activity:
YEAR ENDED
DECEMBER 31,
---------------
2000 1999
------ ------
Balance at beginning of year............................ $18.45 $ --
Granted............................................... 78.36 18.92
Exercised............................................. 15.55 --
Canceled.............................................. 60.63 22.76
Balance at end of year.................................. 42.55 $18.45
The weighted average exercise price of exercisable options was $16.60 in
2000, $17.00 in 1999, and $8.07 in 1998. The per share weighted average fair
value of options granted were $40.66 in 2000, $12.67 in 1999, and $14.84 in
1998.
Under the 1999 Plan, options were granted to certain employees of Digex at
exercise prices below the fair market value of Digex common stock at the date of
the grant. The options granted during 2000 and 1999 are summarized as follows:
2000 1999
--------------------- ---------------------
WEIGHTED WEIGHTED
WEIGHTED AVERAGE WEIGHTED AVERAGE
AVERAGE EXERCISE AVERAGE EXERCISE
FAIR VALUE PRICE FAIR VALUE PRICE
---------- -------- ---------- --------
Exercise Price = Fair Market Value.... $64.60 $79.30 $12.13 $21.33
Exercise Price
(greater than) Fair Market Value.... -- -- 8.47 17.00
Exercise Price
(less than) Fair Market Value....... 57.69 41.15 15.63 9.85
$40.66 $78.36 $12.67 $18.92
F-14
64
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The range of option exercise prices for options outstanding as of December
31, 2000 was $5.00 to $139.38. The range of exercise prices for options is wide
due primarily to the increasing price of Digex common stock over the period in
which the option grants were awarded. The options outstanding as of December 31,
2000 are summarized in ranges as follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------- ----------------------------
WEIGHTED
WEIGHTED AVERAGE WEIGHTED
AVERAGE REMAINING AVERAGE
EXERCISE CONTRACTUAL LIFE EXERCISE
RANGE OF EXERCISE PRICES SHARES PRICE (IN YEARS) SHARES PRICE
------------------------ --------- -------- ---------------- --------- ----------------
$ 5.00 - $ 10.00........... 941,156 $ 5.29 8.62 284,736 $ 5.22
$17.00 - $ 17.00........... 2,673,461 17.00 8.58 855,246 16.61
$21.18 - $ 48.18........... 1,646,650 40.60 9.30 155,209 31.38
$54.18 - $ 74.94........... 1,831,702 67.79 9.46 25,065 54.19
$78.00 - $139.38........... 833,080 115.02 9.23 -- --
--------- ------- -------- --------- ------
7,926,049 $ 42.55 9.01 1,320,256 $16.60
Retirement Plan
Digex has established a 401(k) profit-sharing plan. Employees 21 years or
older with at least three months of service are eligible to participate in the
plan. Participants may elect to contribute, on a tax-deferred basis, up to 15%
of their compensation, not to exceed $10,500 during the taxable year. Digex will
match one-half of a participant's contribution, up to a maximum of 7% of the
participant's compensation. Digex's matching contribution fully vests after
three years of service. Digex's contributions to the plan were $1.1 million in
2000, $0.5 million in 1999, and $0.2 million in 1998.
8. INCOME TAX INFORMATION
Digex files a consolidated income tax return with its wholly owned domestic
subsidiary. Separate returns are filed for its foreign subsidiaries. The
consolidated tax provision, therefore, is based upon the separate tax provisions
of the domestic and foreign jurisdictions.
Domestic and foreign loss before the benefit from income taxes consists of
the following (in thousands):
YEAR ENDED DECEMBER 31,
---------------------------------------
2000 1999 1998
----------- ---------- ----------
Domestic.......................... $ (135,171) $ (69,838) $ (16,740)
Foreign........................... (7,764) -- --
----------- ---------- ----------
Total........................ $ (142,935) $ (69,838) $ (16,740)
=========== ========== ==========
F-15
65
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Income tax benefit for the tax years ended December 31 is comprised of the
following (in thousands):
YEAR ENDED DECEMBER 31,
-------------------------------
2000 1999 1998
--------- -------- --------
Current................................... $ -- $ -- $ --
Deferred:
Federal.............................. -- 4,244 144
State................................ -- 595 15
--------- -------- --------
$ -- $ 4,839 $ 159
========= ======== ========
The following table reconciles the assumed statutory tax rate with the
effective rate to income tax expense:
YEAR ENDED DECEMBER 31,
-----------------------
2000 1999 1998
----- ----- -----
Tax benefit at statutory rate................... (34.0)% (34.0)% (34.0)%
Reconciling items:
State income taxes, net....................... (3.2)% (3.2)% (3.1)%
Non-deductible items.......................... 0.7% 3.3% --
Change in valuation allowance................. 36.3% 19.1% 32.0%
Foreign taxes................................. 0.2% -- --
Other items................................... -- 7.8% 4.1%
----- ----- -----
Effective tax rate.............................. (0.0)% (7.0)% (1.0)%
----- ----- -----
At December 31, 2000 and 1999, Digex had temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
the amounts used for income tax purposes. Significant components of the deferred
tax assets and liabilities were as follows (in thousands):
DECEMBER 31,
-------------------
2000 1999
-------- --------
Deferred tax liabilities:
Depreciation and amortization...................... $ (6,485) $ --
Identifiable intangible assets..................... (3,748) (4,299)
-------- --------
Total deferred tax liabilities.................. (10,233) (4,299)
Deferred tax assets:
Net operating loss carryforwards -- U.S. .......... 74,567 18,449
Net operating loss carryforwards -- Foreign........ 2,320 --
Allowance for bad debts............................ 2,289 1,636
Depreciation and amortization...................... -- 1,867
Contingent tax accrual............................. 266 352
Deferred revenue................................... 4,410 --
Stock-based compensation........................... 1,630 487
-------- --------
Total deferred tax assets....................... 85,482 22,791
Less: valuation allowance....................... (75,249) (18,492)
-------- --------
Net deferred tax asset........................ 10,233 4,299
-------- --------
Net deferred tax asset (liability)................... $ -- $ --
======== ========
F-16
66
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
As a result of the recapitalization of Digex on April 30, 1999, the net
operating loss carryforwards of Digex as of December 31, 1998 did not transfer
to Digex after the recapitalization. Accordingly, a net deferred tax liability
of $4.8 million relating to identifiable intangible assets was recorded as a
result of the recapitalization on April 30, 1999. Digex generated net operating
losses and non-deductible expenses in excess of the deferred tax liability after
the recapitalization and recorded the deferred tax asset associated with the
future deductible items. Accordingly, Digex recorded a $4.8 million deferred tax
benefit during the year ended December 31, 1999.
SFAS 109 requires a valuation allowance to reduce the deferred tax assets
reported if, based on the weight of the evidence, it is more likely than not
that some portion or all of the deferred tax assets will not be realized. After
consideration of all the evidence, both positive and negative, management has
determined that a $75.2 million valuation allowance at December 31, 2000 is
necessary to reduce the deferred tax assets to the amount that will more likely
than not be realized. The increase in the valuation allowance for the current
year is $56.8 million. At December 31, 2000, Digex's net operating loss
carryforwards for income tax purposes are approximately $205.2 million, with
expiration periods beginning in 2019 through 2020.
9. LOSS PER SHARE
On April 30, 1999, Digex issued 1,000 shares of Class B Common Stock to
Intermedia in connection with the contribution of assets to Digex. Loss per
share is presented on a pro forma basis prior to that period assuming that the
common shares issued in connection with the recapitalization on April 30, 1999
were outstanding for all periods of Digex presented. On July 23, 1999, the Board
of Directors authorized a 50,000-for-one split of the Class B Common Stock,
effective as of August 4, 1999 and paid in the form of a stock dividend for
shares outstanding as of July 8, 1999. The basic and diluted net loss per common
share were calculated assuming that the stock split was effective for all
periods presented. All share information presented gives effect to the stock
split.
The following table sets forth computation of basic and diluted loss per
share of common stock (amounts in thousands, except share and per share
information):
YEAR ENDED DECEMBER 31,
---------------------------------------
2000 1999 1998
----------- ----------- -----------
Net loss, as reported............... $ (143,101) $ (64,999) $ (16,581)
=========== =========== ===========
Weighted average number of common
shares............................ 63,404,839 54,726,027 50,000,000
=========== =========== ===========
Loss per share:
basic and diluted................. $ (2.26) $ (1.19) $ (0.33)
=========== =========== ===========
Convertible securities (convertible preferred stock, warrants, and stock
options) were excluded from the computation of diluted loss per share because
assumed exercise or conversion would be anti-dilutive.
F-17
67
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
10. COMPREHENSIVE LOSS
The following table reflects the calculation of comprehensive losses for
the year ended December, 31, 2000, 1999, and 1998 (in thousands):
2000 1999 1998
----------- ---------- ----------
Net loss applicable to common
stockholders........................ $ (143,101) $ (64,999) $ (16,581)
----------- ---------- ----------
Other comprehensive loss:
Foreign currency translation
adjustments...................... (38) -- --
----------- ---------- ----------
Comprehensive loss applicable to
common stockholders................. $ (143,139) $ (64,999) $ (16,581)
=========== ========== ==========
11. RELATED PARTY AGREEMENTS
General and Administrative Services Agreement
On April 30, 1999, Digex entered into a General and Administrative Services
Agreement (the "G&A Agreement") with Intermedia. Under the terms of the G&A
Agreement, as amended to date, Intermedia provided Digex with back office and
administrative services such as human resources, finance and accounting, tax
services, investor relations, treasury, and information management services.
This agreement has an initial term of two years and expires in April 2001. The
charge for these services was $15.0 million in 2000 and $16.5 million in 1999.
Rates charged to Digex in 1999 and 1998 for these services prior to the G&A
Agreement are believed to be consistent with the allocations in the accompanying
financial statements. Rates for services not previously provided to Digex (e.g.
investor relations) were based upon Intermedia and Digex's best estimate of the
fair value of those services.
Network Services Agreements
Pursuant to three Network Services Agreements between Intermedia and Digex
entered into in July 1999, Intermedia has been providing Digex with east and
west coast Internet transit, Internet access and managed firewall services.
These agreements have an initial term of two years and expire in July 2001. The
charges for these services amounted to $5.0 million in 2000 and $7.8 million in
1999. Rates charged to Digex in 1999 and 1998 prior to the Network Services
Agreements were generally consistent with rates incurred during the periods
presented in the accompanying consolidated financial statements.
Asset Migration Agreement
On June 1, 2000, Digex entered into an Asset Migration Agreement with
Intermedia. Under the terms of the agreement, Digex purchased certain assets,
including certain licensed third-party software, machinery, and equipment from
Intermedia at cost to provide independent managed firewall services. In
connection with the purchase of firewall-related assets from Intermedia, the
Managed Firewall Services Agreement between Digex and Intermedia was terminated.
Digex paid a purchase price of $4.5 million for the net book value of these
assets and services on June 30, 2000, the closing date of the agreement. Under
the Asset Migration Agreement, Digex has made equal monthly installments of $0.9
million for Intermedia's support and consultation for the six months ended
December 31, 2000.
F-18
68
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Expense Sharing and Indemnity Arrangements
On January 24, 2000, Digex agreed with Intermedia to allocate and pay the
expenses of its February 2000 public offering, including any amounts arising
from any indemnification or contribution obligations, in proportion to the
number of shares of Class A Common Stock sold by Digex and by Intermedia.
Expenses of $0.3 million were allocated to Digex in 2000 and were netted against
offering proceeds.
Sale of Telecommunications Related Assets to Intermedia
Digex entered into three Use of Proceeds Agreements with Intermedia on June
2, 1999, January 11, 2000, and January 24, 2000, respectively, to sell to
Intermedia certain telecommunications related assets that were purchased by
Digex with the net proceeds of certain offerings of Digex securities and the
cash proceeds of the investments by Microsoft and Compaq. The assets were sold
to Intermedia at Digex's cost. The proceeds from the sale of telecommunications
related assets to Intermedia were approximately $33.7 million and $25.3 million
during the years ended December 31, 2000 and 1999, respectively. These proceeds
were unrestricted and used to fund Digex's operating expenses. Net proceeds from
the equity offerings were fully used as of December 31, 2000.
Guaranty Agreement
On October 31, 2000, Intermedia increased the commitments available to it
under its Revolving Credit Facility ("Credit Facility") from $100.0 million to
$350.0 million. As a subsidiary of Intermedia, Digex will be a limited guarantor
under the Credit Facility to the greater of $90.0 million or the amounts
borrowed by Digex. The Credit Facility is also fully guaranteed by WorldCom. At
December 31, 2000, Intermedia had $113.0 million outstanding under its Credit
Facility.
Software, Equipment and Services Purchased from Microsoft and Compaq
In January 2000, Digex entered into strategic development agreements and
joint marketing arrangements with Microsoft and Compaq. Digex and Microsoft will
work together to advance Digex's capabilities to more rapidly install, manage
and upgrade large numbers of Microsoft Windows-based servers for Web site and
application hosting. Digex and Compaq will work jointly to streamline the order,
delivery and installation of Compaq's server hardware and storage devices. In
connection with these agreements, Microsoft and a subsidiary of Compaq made a
$100.0 million equity investment in Digex, of which $85.0 million was paid in
cash and $15.0 million was paid in the form of equipment credits from Compaq.
Digex has in the past purchased and expect to continue to purchase computer
hardware, software and certain consulting services from both Microsoft and
Compaq pursuant to certain arrangements negotiated prior to or in connection
with the investment by Microsoft and Compaq in Digex. Digex purchased $2.7
million in 2000, $3.1 million in 1999, and $1.1 million in 1998 for products and
services provided by Microsoft. Digex purchased $26.6 million (excluding $2.7
million of equipment credits) in 2000, $18.7 million in 1999, and $7.5 million
in 1998 for products and services provided by Compaq.
12. LEASE COMMITMENTS AND NOTE PAYABLE
On June 29, 2000, Digex entered into a ten-year lease commencing in
September 2000 for its new corporate headquarters facility in Laurel, Maryland.
The lease agreement requires an initial security deposit of $2.0 million in the
form of a letter of credit. This letter of credit may be reduced at the
commencement of the seventh lease year to an amount equal to the then current
one month's base rent if certain conditions are met annually prior the seventh
year of the lease. Property and equipment include the present value of the
capital lease which is amortized over the term of the lease.
F-19
69
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Digex leases office space and vehicles under capital lease arrangements.
Digex also leases office space and office equipment under operating leases.
Future noncancelable lease payments under Digex's lease commitments at December
31, 2000 are as follows (in thousands):
CAPITAL OPERATING
LEASES LEASES
-------- ---------
Future minimum lease payments:
Year ended December 31:
2001....................................... $ 4,374 $ 3,921
2002....................................... 4,483 2,925
2003....................................... 4,716 2,401
2004....................................... 4,642 2,378
2005....................................... 4,774 2,014
Thereafter................................... 19,920 3,129
-------- -------
42,909 $16,768
=======
Less amount representing interest............ (13,907)
--------
Present value of lease payments.............. 29,002
Current portion of capital leases............ (1,871)
--------
Noncurrent portion of capital leases......... $ 27,131
========
Rent expense amounted to $3.9 million, $2.0 million, and $0.8 million for
the years ended December 31, 2000, 1999, and 1998, respectively. Lease payments
under operating leases include certain rent allocated to Digex in 1999.
Digex expects to enter into a master lease and financing agreement with a
vendor for a line of credit of up to $25.0 million to facilitate the leasing of
computer hardware and software in the future. The initial term of the agreement
ranges from 24 to 36 months. Digex has an option to purchase the equipment at
the end of the initial lease term.
A note payable of $4.7 million was issued in 1999 in connection with the
purchase of software. The note accrues at an effective interest rate of 7.00%
per annum and matures in January 2002. Principal repayments until maturity are
as follows (in thousands):
Year ended December 31:
2001................................................ $2,772
2002................................................ 1,435
------
Total................................................. $4,207
======
Interest cost incurred and charged to expense related to the note payable
was $0.3 million in 2000 and $0.2 million in 1999.
13. CONTINGENCIES
On September 5, 2000, and thereafter, Intermedia, Digex, the directors of
Digex, and in some cases, WorldCom, were named as defendants in a total of
thirteen lawsuits in the Court of Chancery of the State of Delaware in and for
New Castle County. Of those thirteen lawsuits, eight were brought as class
actions on behalf of Digex public shareholders, three were brought as derivative
actions, purportedly on behalf of Digex, and two advanced both class action and
derivative claims. On October 17, 2000, the Court ordered that all thirteen
lawsuits to be consolidated into a single combined derivative and class action.
F-20
70
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In general, the complaints advanced substantially similar allegations that
the defendants breached their fiduciary duties to the class members by acting to
further their own interests at the expense of Digex public stockholders, by
engaging in self-dealing and by failing to act in good faith towards the Digex
public stockholders. The complaints claimed that such alleged wrongdoing caused
irreparable harm to such stockholders. In addition, four of the complaints
alleged that the Digex board members who are also directors or executive
officers of Intermedia conferred a substantial benefit on Intermedia at the
expense of the Digex public stockholders by voting to waive application of
Section 203 of the Delaware General Corporation Law to future transactions
between WorldCom and Digex. These complaints also alleged that WorldCom aided
and abetted the wrongdoing of Intermedia's and the Intermedia-affiliated
directors of Digex. The complaints sought injunctive relief and unspecified
damages.
On February 15, 2001, a memorandum of understanding was executed on behalf
of all interested parties in the consolidated actions, setting forth an
agreement in principle providing for the settlement of all actions in their
entirety. WorldCom will make a settlement payment of WorldCom common stock
having a total value of $165.0 million for distribution to Digex common stock
holders. One half of the settlement fund net of plaintiffs' attorneys fees will
be distributed to record holders of Digex common stock on September 1, 2000. The
balance of the settlement fund net of attorneys' fees will be paid to record
holders of Digex stock at the time of the consummation of the merger. Neither
Intermedia nor its affiliates will be entitled to any distribution from the
settlement fund. The merger agreement between Intermedia and WorldCom will be
amended to change the consideration to be paid to Intermedia shareholders in
connection with the merger. All fees and expenses of all plaintiffs and all
counsel representing all plaintiffs in the action will also be paid out of that
settlement fund. In connection with the proposed settlement, WorldCom will
reimburse Digex for certain fees and expenses incurred by Digex associated with
the merger and the consolidated lawsuit in an amount not to exceed $15.0
million. WorldCom has also agreed to enter into certain commercial agreements
with Digex. A further provision of the settlement will make Section 203 of the
Delaware General Corporation Law inapplicable to future transactions between
WorldCom and Digex. The proposed settlement would, if approved by the Court,
fully resolve all claims in the lawsuit.
On March 2, 2001, Digex, WorldCom, and Intermedia entered into a definitive
Stipulation of Settlement with all relevant parties to settle all claims related
to the consolidated class action and derivative action in accordance with the
terms agreed to in the February 15, 2001 memorandum of understanding. The Court
has entered an order directing that notice of the settlement be sent to members
of the class and has scheduled a settlement hearing to be held on April 6, 2001
in the Delaware Court of Chancery in Wilmington, Delaware. The final settlement
of the suit is subject to the satisfaction of certain conditions as well as
final court approval. Based on the memorandum of understanding and the
Stipulation of Settlement, Digex does not expect to have any future liability
from the outcome of this litigation.
Digex also does not believe that there are any other pending or threatened
legal proceedings that, if adversely determined, would have a material adverse
effect on Digex's results of operations, cash flows, or financial position.
F-21
71
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of unaudited quarterly results of operations for
the years ended December 31, 2000 and 1999 (in thousands):
2000
--------------------------------------------------------------------------------------------------
FIRST SECOND THIRD FOURTH
--------------------------- --------------------------- --------------------------- --------
AS AS AS
PREVIOUSLY PREVIOUSLY PREVIOUSLY
REPORTED AS RESTATED(1) REPORTED AS RESTATED(1) REPORTED AS RESTATED(1)
---------- -------------- ---------- -------------- ---------- --------------
Revenues................ $ 27,974 $ 25,796 $ 42,222 $ 40,368 $ 46,531 $ 43,979 $ 57,942
Operating expenses...... 56,677 54,568 80,119 78,325 87,343 84,875 100,930
-------- -------- -------- -------- -------- -------- --------
Loss from operations.... (28,703) (28,772) (37,897) (37,957) (40,812) (40,896) (42,988)
Other income
(expense)............. 3,057 3,057 3,472 3,472 (393) (393) 1,542
-------- -------- -------- -------- -------- -------- --------
Income tax benefit...... -- -- -- -- -- -- --
-------- -------- -------- -------- -------- -------- --------
Loss before cumulative
effect of change in
accounting
principle............. (25,646) (25,715) (34,425) (34,485) (41,205) (41,289) (41,446)
Cumulative effect of
change in accounting
principle............. -- (166) -- -- -- -- --
-------- -------- -------- -------- -------- -------- --------
Net loss................ $(25,646) $(25,881) $(34,425) $(34,485) $(41,205) $(41,289) $(41,446)
======== ======== ======== ======== ======== ======== ========
Loss per Common
Share(2):
basic and diluted..... $ (0.41) $ (0.41) $ (0.54) $ (0.54) $ (0.65) $ (0.65) $ (0.65)
======== ======== ======== ======== ======== ======== ========
1999
----------------------------------------
FIRST SECOND THIRD FOURTH
------- -------- -------- --------
Revenues.................................................... $ 9,392 $ 12,629 $ 16,111 $ 21,654
Operating expenses.......................................... 17,987 30,482 37,803 45,716
------- -------- -------- --------
Loss from operations........................................ (8,595) (17,853) (21,692) (24,062)
Other income (expense)...................................... -- (239) 920 1,683
------- -------- -------- --------
Income tax benefit.......................................... -- 4,839 -- --
------- -------- -------- --------
Net loss.................................................... $(8,595) $(13,253) $(20,772) $(22,379)
======= ======== ======== ========
Loss per Common Share:
basic and diluted......................................... $ (0.17) $ (0.27) $ (0.36) $ (0.36)
======= ======== ======== ========
- ---------------
(1) Restated for the effect of the implementation of SAB 101 (See Note 1).
(2) Represents loss before cumulative effect of change in accounting principle
and net loss per common share.
F-22
72
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
15. SUBSEQUENT EVENTS
In January 2001, Digex received a $3.0 million loan from the State of
Maryland Department of Business and Economic Development under the Sunny Day
Fund initiative. The loan is subject to multiple maturity dates, and is
guaranteed by Intermedia. Interest on the unpaid principal balances accrues at
5% per annum. The principal amounts and any accrued interest will be deferred
each year through December 31, 2008 if Digex meets certain annual conditions
regarding the hiring of permanent, full time employees and the expenditures for
the development of a Web hosting facility in Prince George's County, Maryland.
At December 31, 2008, the principal amounts and any accrued interest outstanding
may convert to a grant upon the achievement of certain requirements by Digex.
Also in January 2001, the Federal Communications Commission approved the
merger between WorldCom and Intermedia on the condition it comply with an
agreement reached with antitrust authorities that WorldCom divest certain
Intermedia assets and operations.
On March 2, 2001, Digex and certain subsidiaries of WorldCom agreed to
enter into four commercial agreements. These commercial agreements will become
effective at or before the consummation of the Intermedia-WorldCom Merger
pursuant to the merger agreement. The principal terms of the four commercial
agreements are generally described as follows:
-- Sales Channel Agreement. Under this agreement, WorldCom will
resell the Digex portfolio of managed Web hosting products. If
Digex satisfies certain service level commitments, WorldCom agrees
to purchase up to a total of $500.0 million during the period from
2001 through 2003. Digex and WorldCom will share costs and profits
generated from the WorldCom sales channel.
-- Funding Agreement. After the completion of the Intermedia-WorldCom
Merger, WorldCom's Board of Directors will review the Digex
business plans for 2001 and 2002 approved by the Digex Board of
Directors. If these business plans are approved by the WorldCom
Board of Directors, WorldCom agrees to loan Digex funds for these
business plans; the loan rate will be LIBOR plus 300 basis points.
Repayment will be made over a four-year period commencing in 2003.
However, the funding agreement would not prevent Digex from seeking
replacement funding from other sources.
-- Facilities Agreement. Managed Web hosting facilities for Digex
will be built into several WorldCom data centers in the United
States and around the globe. Digex will lease space from WorldCom
at these data centers based on customer demand.
-- Network Agreement. This agreement permits Digex to purchase
bandwidth and connectivity from WorldCom in the United States to
support its managed Web hosting activities.
Digex expects to continue experiencing negative cash flow from operating
and investing activities due to its plans for expansion and the growth of the
business. As described above, Digex has entered into a series of commercial
arrangements with WorldCom. These favorable agreements are subject to
termination if, among other things, the Intermedia-WorldCom Merger is not
completed prior to December 31, 2001. Completion of the Intermedia-WorldCom
Merger is subject to a number of conditions. While Digex believes it is probable
the Intermedia-WorldCom Merger will close, if for any reason it does not, Digex
might no longer have the benefit of the WorldCom commercial agreements or the
funding to be made available by WorldCom for its 2001 and 2002 business plans.
In addition, if the Intermedia-WorldCom Merger did not close, Intermedia would
no longer be able to borrow under its existing credit facility or note purchase
agreement with WorldCom and would unlikely be able to provide Digex with any
additional funding for working capital needs, operating losses or capital
expenditure requirements.
F-23
73
DIGEX, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In the event the Intermedia-WorldCom Merger does not close, Digex's
intention would be to access the capital markets for their necessary funding.
Management has had preliminary discussions with third party sources regarding
potential financing, including vendor financing facilities or other asset backed
secured financing. Based on these discussions, management believes Digex will
have access to capital markets to obtain sufficient funding to continue its
business plans as described above or, at a minimum, in an amount that would
provide sufficient funding to execute a modified or curtailed plan into 2002.
F-24
74
DIGEX, INCORPORATED
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
(AMOUNTS IN THOUSANDS)
ADDITIONS
-----------------------
BALANCE AT CHARGED TO CHARGED DEDUCTIONS BALANCE AT
BEGINNING COSTS AND TO OTHER -- END OF
DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DESCRIBE PERIOD
- ----------- ---------- ---------- ---------- ---------- ----------
For the year ended December 31, 1998:
Deducted from asset accounts:
Allowance for doubtful accounts...... $ 369 $ 1,491 -- $ 1,141(1) $ 719
========== ========== ========== ========== ==========
Allowance for deferred tax
accounts........................... -- $ 5,349 -- -- $ 5,349
========== ========== ========== ========== ==========
For the year ended December 31, 1999:
Deducted from asset accounts:
Allowance for doubtful accounts...... $ 719 $ 4,265 -- $ 622(1) $ 4,362
========== ========== ========== ========== ==========
Allowance for deferred tax
accounts........................... $ 5,349 $ 13,143 -- -- $ 18,492
========== ========== ========== ========== ==========
For the year ended December 31, 2000:
Deducted from asset accounts:
Allowance for doubtful accounts...... $ 4,362 $ 10,649 -- $ 10,270(1) $ 4,741
========== ========== ========== ========== ==========
Allowance for deferred tax
accounts........................... $ 18,492 $ 56,757 -- -- $ 75,249
========== ========== ========== ========== ==========
- ---------------
(1) Uncollectible accounts written off, net of recoveries.
F-25